Just day’s after Baupost’s Jim Mooney wrote a letter warning of dangerous volatility patterns and risks of systematic strategies such as risk parity exacerbating a S&P 500 sell off, JPMorgan’s derivatives strategist Marko Kolanovic is piling on the issue, one he has long addressed. In a research note out Thursday afternoon, Kolanovic also notes troubling market patterns that point to the tranquil market environment being disrupted by the withdrawal of central bank quantitative dopamine. It all points to volatility concerns amid a market environment beset by historically low volatility. But the news is not all bad, he observes.

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S&P 500 Sell Off

S&P 500 Sell Off ahead? Kolanovic expresses concern as the Federal Reserve goes on a diet

The US Federal Reserve has been able to engineer interest rate increases without much market disruption. The last several rate hikes and even hawkish talk out of the Fed has not led to a S&P 500 sell off, a feat punctuated in accomplishment when considering the August 2015 market crash that some analysts credited with being due to consideration of rising interest rates.

But a related concern is starting to creep into markets. Kolanovic notes that “increased risks are building for September” as the Fed looks to pare down its more than $4 trillion balance sheet, a feat unprecedented in history.

When this happens, Kolanovic suggests hedge long stock market exposure using one of two “current extremes in the derivatives markets.”

The record low level of stock market volatility, taking advantage by purchasing insurance protection is recommended through the CBOE VIX index. Kolanovic, like Jeffery Gundlach, who recently purchased five-month put options on the S&P 500, thinks a “1 by 2” ratio put spread would also serve as an appropriate risk management tool. This entails an investor purchasing one S&P 500 2450 strike put and selling two 2300 strike put options expiring January 2018. This unbalanced spread can be done at no cost (~20bps cost) and provides protection to a limited degree. Once the S&P moved past 2300 on the downside, however, the protection would start to lessen with the investor committing to double down near 2150.

Kolanovic: Market is at a "turning point"

In part driving Kolanovic’s concern is a correlation decoupling between stocks and sectors that occurred with “unprecedented speed and magnitude.” Sharp changes in correlation patterns, particularly when they have a fundamental anchor, are a sign to some analysts as to a market shift ahead.

This correlation divergence pattern has only occurred twice in history, in 1993 and 2000 and was later followed by S&P 500 sell off in 1994 and 2001.

Declining correlations that started after the US Presidential elections pushed market volatility lower, a point exacerbated by the nearly 25% higher in stock prices since November 2016. The current market pattern resembles the lead up to the 1994 and 2001 market crashes, Kolanovic observes.

“Investors should be aware of hidden leverage and tail risk of a more significant correction,” he wrote, pointing to a similar concern expressed by Baupost’s Mooney.

Calling the current low volatility environment “a turning point,” Kolanovic pointed to option hedging, Volatility Targeting, CTAs, Risk Parity as strategies that are systematically built to sell as the stock market sells off and volatility rises. “Low volatility would not be a problem if not for strategies that increase leverage when volatility declines,” he wrote.  “Additionally, growth in short volatility strategies in a self-fulfilling manner suppresses both implied and realized volatility. The fact that we had many volatility cycles since 1983, and are now at all-time lows in volatility, indicates that we may be very close to the turning point.”

There is positive earnings fundamentals, Kolanovic notes, pointing to a near 12% rise in year over year S&P 500 results – a key metric used in the price/earnings ratio used by many analysts to determine fair market value for stocks. While risks abound, some of the risks are to the upside, particularly if the Trump administration can make progress on tax reform.