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"We May Be Very Close To The Turning Point": Selloff Blamed On This Note From JPM's Marko Kolanovic

While nobody knows what catalyzed for the sharp selloff over the last hour, with Citi (no really) blaming it on Acrophobia, or fear of heights, saying  that "US equities opened at record highs, key levels were being approached in fixed income while USD enjoyed a bid across the board... However since then, it looks like markets have gotten a small case of cold feet", Bloomberg had a different idea, when it observed that stocks erased gains around 12:30 p.m. as S&P 500 fell 0.5% over 60 minutes to low of 2,469.51. It notes that the "weakness occurred as traders circulated a note by JPMorgan quant strategist Marko Kolanovic that cautioned investors on the risks of record-low volatility in the equity market."

In his latest note, reposted below, Kolanovic, aka the JPM quant "Gandalf" popularized on this website over the past two years writes that "volatility near or at record lows by a handful of measures should “give pause to equity managers,” and that “low volatility would not be a problem if not for strategies that increase leverage when volatility declines.”

For the TL/DR crowed, picking up on an article posted here two days ago in which MS explained what would happen if VIX went "bananas", Kolanovic writes that "strategies that boost leverage when volatility declines, such as option hedging, CTAs and risk-parity, share similar features with the dynamic ‘portfolio insurance’ of 1987,” which “creates a ‘stop-loss order’ that gets larger in size and closer to the current market price as volatility gets lower.”  Additionally, growth in short-vol strategies suppresses both implied and realized volatility, and with volatility at all-time lows “we may be very close to the turning point.”

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Here is his full note below

Solid Equity Fundamentals but Threat of Low Volatility and Balance Sheet; Correlation Parallels to '94 and '01

It has been a quiet summer so far. In fact, over the past two weeks the VIX closed below 10 every day – marking a period of the lowest volatility in the history of option trading (since 1983). Equity markets are supported by positive fundamental developments in the US and abroad, but are facing two near-term known risks: extremely low volatility and prospects of central banks’ balance sheet reduction. These are discussed below.

Positive: Earnings fundamentals

Our current forecast for 2017 S&P 500 earnings is $132, which we recently revised up. The ~12% YoY increase in S&P 500 earnings is a result of both revenue growth and margin expansion. A significant positive development was the ~8% decline in the trade-weighted USD, and nearly half of that decline happened in the last month alone. Higher revenues also reflect stronger global GDP growth (3.1% for 2017 vs 2.6% last year, and 3.6% in Q2 vs 3.0% in Q1), higher interest rates and higher oil prices (relative to last year). In addition to improved macro fundamentals, there is a further upside risk should the Administration make progress on US corporate tax reform; for example, we are currently modeling $9 in earnings upside if the tax rate declines to 28%. These are all positives.

Risk: Extreme low volatility

It is safe to say that volatility has reached all-time lows, and this should give pause to equity managers. Low volatility would not be a problem if not for strategies that increase leverage when volatility declines. Many of these strategies (option hedging, Volatility targeting, CTAs, Risk Parity, etc.) share similar features with the dynamic ‘portfolio insurance’ of 1987. While these strategies include concepts like ‘risk control,’ ‘crisis alpha,’ etc., in various degrees they rely on selling into market weakness to cut losses. This creates a ‘stop loss order’ that gets larger in size and closer to the current market price as volatility gets lower. Additionally, growth in short volatility strategies in a self-fulfilling manner suppresses both implied and realized volatility. This in turn prompts other investors to increase leverage, and those that hedge with options lose out and eventually throw in the towel. 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.

Risk: Extreme monetary accommodation

Global central banks are likely to commence reducing their balance sheet accommodation (level for Fed, and inflows for ECB/BOJ) in the near future. We wrote about the impact of this ‘receding tide’ on market volatility and valuations (see here). In what is akin to the law of ‘communicating vessels,’ once inflows in bonds stop, funds are likely to start leaving other risky assets as well, including equities. The FOMC statement yesterday alleviated immediate fears – normalization of balance sheet will start ‘relatively soon,’ but only if ‘the economy evolves broadly as anticipated.’ This reasonably dovish stance pushes this market risk out for a few weeks (the next ECB meeting is Sep 7th, Fed Sep 20th, BoJ Sep 21st). This gives volatility sellers and other levered investors a limited window to position for a seasonal pickup in volatility and central bank catalysts in September.

Taking into account the solid equity fundamentals, but increased risks that are building for September – we suggest investors hedge their long equity exposure. One can take advantage of two current extremes in the derivatives market: a record low level of option volatility, and nearly record high level of option ‘skew’ (relative price of out-of-the-money options). An equity hedge that incorporates these extremes is “1 by 2 put spreads.” Investors can buy one S&P 500 2450 strike put and sell two 2300 strike put options that expire in January 2018 at nearly no cost (~20bps cost). This gives protection if the market drops below ~2450 (but also commits investor to double down below ~2150).

Decline in correlations and parallels to 1994 and 2001

Over the past year, correlation of stocks and sectors declined at an unprecedented speed and magnitude (see figure below). A similar decorrelation occurred on only two other occasions over the last 30 years: in 1993 and 2000. Both of those episodes led to subsequent market weakness and an increase in volatility (in 1994, and 2001). The current decline in market correlations started following the US elections and was largely driven by macro (rather than stock-specific) forces. Expectation of fiscal measures, deregulation and higher interest rates set in motion large equity sector and style rotations. For instance, the correlation between Financials and Technology dropped to all-time lows (similar level during the tech bubble). The correlation between equity styles also dropped (e.g., Value was lifted by rates, and Low Volatility was impacted negatively). Declining correlations pushed market volatility lower (see here), and the ~25% market rally further suppressed correlations and volatility. To investigate what are potential implications for the future price action, we look at the 1993 and 2000 decorrelation events.

  • 1993/1994: Following the 1990-91 recession, interest rates declined and the market rallied. By late 1993, the market reached its highs (60% above recession lows) and volatility plummeted (VIX hit a record low on 12/22/1993). This also marked the low point of equity correlations. As interest rates increased in 1994, the market experienced a ~10% correction and posted a negative return for the year. Volatility and correlation increased, but the crisis was contained given the acceleration of growth (US GDP increased from 2.6% to 4.3% in the first half of 1994), and subsequent decline in bond yields.
  • 2000/2001: Following the 1998 crisis (LTCM, Russia), the market recovered and continued to rally. When the internet bubble was inflated, the market was 60% above 1998 lows. This period was marked with a strong decoupling of sectors (e.g., tech vs. financials), distorted valuations, elevated volatility and gradually rising interest rates. It ended with the tech bubble in March 2001, which marked the low point of equity correlation and start of recession. Subsequently, the market declined ~30%, bottoming in late 2002.

The current episode of correlation decline shares some similar features with both 1993 and 2000. The decline of correlation was in part driven by the market rally and elevated valuations; after a period of falling, interest rates are expected to rise (as in 1993), sector valuations (e.g., Internet) and sector rotations play an outsized role in market price action (similar to 2000), and record low levels of volatility increased the level of risk taking (as in 1993). Normalization of monetary policy will most likely lead to an increase of correlations and volatility, and that will at some point result in market weakness. While it seems that the 1993/1994 analogy is more appropriate (implying an orderly price action), investors should be aware of hidden leverage and tail risk of a more significant correction, such as the one in 2001.

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Not scary enough? Then read: "If The VIX Goes Bananas" This Is What It Will Look Like