Earlier today, we discussed how after the last 2-day furious selloff, the human-machine-human fingerpointing blame game had begun, with carbon-based traders accusing such systematic and risk-targeting quant strategies as risk-parity funds, CTAs, volatility targeting funds, and trend followers (which account for about $1.5 trillion in assets) for being behind the sharp selloff. This followed our own take on how much selling CTAs were responsible for on both Wednesday and Thursday, after selling triggers were hit.
Of course, any time there is a discussion of systemic, and quant, trading – and especially selling – JPM’s head quant Marko Kolanovic can not be far behind. Unfortunately, just like during the February selloff, which Kolanovic failed to predict, so this time Marko’s value added is only from the perspective of a post mortem of what everyone else has already observed.
Furthermore, it was Kolanovic who just a few weeks back said that there was no pressure from systematic selling, and instead the only driver of significance was corporate profits which is why he predicted smooth sailing ahead.
So a few moments ago, having failed to predict this week’s selling, the JPMorgan quant released his latest market update and wrote that Wednesday’s selloff was largely technical in nature, “with systematic strategies following the same selling template as in the Feb 5th selloff”, a template which Kolanovic had failed to notice then too.
Discussing the catalyst behind the selling, Kolanovic said that fundamental fears were about rising yields and the Fed’s more hawkish stance, while noting that “in terms of systematic strategies that drove the selloff – by far the biggest selling pressure was from option gamma hedging on Wednesday.“
But don’t worry: the same option gamma hedging risk that Kolanovic failed to warn about, is now supposedly gone or rather, as he puts it “balanced”, and “can turn into a positive impact, i.e. option hedgers buying equities.”
For instance, if the market were to hold its gains during the day, it could result in a squeeze higher by end of the day from gamma hedging flows.
On the other hand, one can counter that with the Dow wiping out most of its gains (at least until the Kolanovic note made the rounds), the selling can accelerate.
According to Kolanovic, other large selling flows were from the same CTAs – which we cautioned about on both Wednesday and Thursday, yet which JPMorgan failed to mention even once – that started in indices such as Russell 2000 and Nasdaq last week, eventually spreading into the S&P 500 on Wednesday.
CTA selling tends to be relatively fast and is likely largely behind us given the already low CTA equity beta, and the fact that 12M momentum on S&P 500 will most likely hold positive (>2550). The remaining part of systematic selling is from volatility targeting (insurance, parity funds, etc.) which will go on for several more days.
In any case, with the market suffering its biggest weekly selloff since February, one which Kolanovic not only did not foresee but instead called for further upside, he is now predictably, optimistic:
Looking at these three groups of sellers, CTAs have already executed the bulk of their selling, option hedging risk is now symmetric, and Volatility Targeters will sell over a longer period of time. As such, we think that the majority of systematic selling is behind us (~70%).
Additionally, Kolanovic notes that since volatility targeting funds tend to sell over a number of days (e.g. 3-10 days for various models), “these flows should be easier to digest by the market”… unless of course they aren’t.
In addition to model buying, the JPMorganite also hopes to boost trader bullishness by noting that flows that may counter selling are “buybacks (e.g. ASR programs not subject to blackout), fundamental buyers attracted by cheap valuation (P/E below historical average), as well as fixed weight portfolio rebalances (e.g. pensions rebalancing on triggers).”
Kolanovic then correctly notes that the amount of systematic assets and leverage was smaller heading into this week than in February (estimate 10-30% smaller); after all most of the February gamma was concentrated amid inverse VIX ETFs, most of whom mercifully blew up after February 5.
So what is Kolanovic’ advice? Simple: buy the dip…
Given that equity indices already experienced comparable declines to February (and e.g. Russell 2000 even a bigger drawdown), we think that the current setup favors buying the dip.
On the other hand anyone who bought the Dow when it opened some 400 points higher was probably not too happy when it dipped in the red shortly after noon. Which is also why Kolanovic felt the urge to hedge his latest rosy forecast:
A risk to the thesis is that market volatility continues to move higher which would result in further outflows from Volatility Targeting funds.
Why does Kolanovic continue to push such a surprisingly optimistic agenda when most of his peers, including Goldman and Morgan Stanley have turned increasingly bearish? For the following simple reason: “We still expect the market to go higher into year-end, and maintain our S&P 500 price target of 3000. We expect a net positive earnings season in October, strong buyback activity in November, and positive seasonal effects in December.“
Hopefully this prediction will be more successful than the one Marko did not make about this week’s option gamma hedging-linked selling. As for what’s really taking place behind the scenes, it appears that JPMorgan still has some stocks to dump to retail hands, while Goldman and MS are largely done liquidating.