JPMorgan: stocks could outperformance into month-end

JPMorgan's Marko Kolanovic said investors are questioning how much of recent equity moves can be attributed to increased recession risk vs. technical flows in this environment of poor liquidity.

JPM's analysts have reasoned that more than half of the recent move in interest rates and inversion of the yield curve was caused by technical drivers (convexity hedging of mortgages, bank portfolios, and variable annuities in poor liquidity conditions) and less than half of the move can be explained by fundamentals such as the growth, inflation, and monetary policy outlook. "This is an important data point for equity investors, as moves in rates (e.g. yield curve inversion) significantly impact investment sentiment,"

Marko wrote, "by looking at various systematic flows in equity markets, we find similar results – i.e. that more than half of equity moves were driven by systematic rather than fundamental trading."Looking at systematic equity flows during (and as a result of) the Wednesday 14th August sell-off, JPMorgan estimates that around USD 75bln of programmatic selling, with around 50% of it coming from index option delta and gamma hedging, around 20% from trend-following strategies, around 15% from volatility targeting strategies, and the remaining 15% from other products (e.g. levered/inverse ETFs, etc.). "While these outflows would have represented about 25% of futures daily volume, in an environment of low liquidity they can be a dominant driver of price action," Marko says, noting that in particular, during August, market depth of S&P 500 futures dropped to near all-time lows. "Within one index point on the S&P 500 (from mid-market), on average there were just around 900 e-mini futures contracts bid/offered – i.e. an approximately USD 130mln sell order could have moved the market by ~1 index point. We estimate that S&P 500 index option hedging flows were likely the single most important driver of price action during both the selloffs and rallies last week.

"What is the current investor positioning, and what type of flows can we expect going forward? "Hedge fund equity beta is currently near all-time lows, in its quarter-percentile. Trend following strategies and volatility targeting strategies also have low exposure, both in their respective 27th percentiles. All else being equal, such low positioning is positive for equity performance going forward," Marko says, adding that "low positioning also reflects negative market sentiment, with the past two readings of the AAII Bull-Bear spread at -22% and -27%, not far from the lows seen in Dec’18 (-28%) and Feb’16 (-29%) that both marked market bottoms."Marko says that equity flows will, to a large extent, be driven by developments around trade, and hence the market will likely continue to be dominated by market disruptive tweets and announcements related to the trade war, which are difficult to foresee.

On the positive side, Marko says JPM is expecting some stabilization in market volatility as dealers’ gamma positioning is now close to neutral (from a sizable short position last week), and this may reduce volatility and marginally improve liquidity."JPMorgan also expects some marginal stabilization, and perhaps a reversal of volatility targeting outflows. "Given the large outperformance of bonds over equities this month, equity inflows are likely to occur next week," noting that it had recently discussed fixed-weight trigger rebalances may have cushioned the market selloff even before calendar month-end (given the large divergence between stock and bond prices), but typically portfolio rebalances happen at month- or quarter-end, "Marko says that even after the stock market recovered some of the losses from last week, we could still see equity inflows and outperformance into month-end. "Bonds delivered their strongest performance in over seven years and are up around 5% MTD, and equities are down around 2% MTD," adding that as things stand, "this performance divergence leaves fixed-weight portfolios around 2% underweight equities, and suggests they are likely to do a sizeable rotation out of bonds and into equities into month-end."JPM's model suggests that these flows could drive a further 1.5% to 2% of outperformance for equities next week - this figure could change, the bank notes based on this week’s performance of stocks and bonds.

(Taken from JPMorgan strategist, Marko Kolanovic conference call, today )