Kolanovic redeemed?
JPMorgan loves to say they told you so
Doctor of theoretical high-energy physics and erstwhile JPMorgan chief strategist Marko Kolanovic spent the months before his departure warning that overcrowded momentum trades, like all things, tend towards disorder. After the events of this past week, you’d forgive the man a moment of quiet self-satisfaction.
Kolanovic’s former team, now led by Dubravko Lakos-Bujas (who may be adopting a Horus / Northman Alexander Skarsgård / Inigo Montoya stance) had this to say about equity rotation, Japan and the carry trade unwind in a note published on Thursday:
Equities no longer a one-way upside trade, instead increasingly a two-sided debate on growth downside risks, Fed timing, crowded positioning, rich valuation, and rising election and geopolitical uncertainties. While the market focus in 1H was largely tied to the path of inflation, 2H focus is quickly turning to growth risks given elevated earnings expectations for 2H24 (+9%) and 2025 (+14%). In our prior strategy reports... we highlighted extreme positioning and momentum crowding that historically led to violent unwinds. We stressed the importance of portfolio diversification and emphasized the abandoned Low Vol equity complex (i.e. defensives such as Utilities) offering attractive orthogonal properties and superior risk/reward (see Figure 6). The current market pullback, in our view, was primarily driven by fears tied to weakening growth and the repricing of recession probabilities. Additionally, divergent central bank policies (i.e. Fed / BOJ) further amplified market volatility, disrupting crowded trades such as the G10 FX Carry (~7 STDev event) with USD/JPY at the epicenter (~5 STDev event). This shock reverberated across asset classes with record 1-day spike in VIX, vanishing liquidity, and forced deleveraging by volatility sensitive and trend-following strategies. While the recent market flush took out some of the froth, equity positioning and valuation still remain at risk especially if growth continues to decelerate and the Fed does not show urgency.
More investment institutions and shrinking stock markets mean the most lucrative trades are becoming increasingly crowded, according to Ludwig Chincarini, professor of finance at the University of San Francisco and author of The Crisis of Crowding, a 2012 book (recommended to FTAV by two traders this week) on the dangers posed by strategies that neglect to account for their own popularity.
“Arbitrageurs trading to exploit anomalies tend to follow the same academic recipe and exhibit correlated trades,” Chincarini wrote in a prescient paper published in April:
This situation and the frequent use of leverage may exacerbate crash risk in anomaly stocks . . . The time it will take to exit the room will depend on both the number of people in the room and the size of the exit door.
Crowding is associated with stronger expected returns but higher liquidity risks, Chincarini notes. Echoing this, JPM write that aggressive deleveraging by volatility targeting strategies stuck in the same handful of trades almost certainly contributed to the market sell-off. And positioning remains extreme even after the recent rush for the exit:
Lakos-Bujas et al (typos theirs):
Momentum is experiencing its third and most impactful unwind in the past year and contributing to the global equity rout ( Figure 5). We have been cautioning investors of a significant market pullback in an event of a momentum unwind (see Risk for Active Managers, AI Halo Effect, and Right-tail Crowding). The rationale behind the argument being—(a) Momentum and Market downside risks are tied together—Momentum mix was and still is dominated by index-moving Mega-caps (i.e. size factor crowding still at 96%ile, Figure 4) and index-sensitive High Beta stocks; (b) Setup ripe for reversal—Momentum had an extreme right tail non-linear crowding one month ago that receached 35-year record high (100%ile), which after this correction has fallen to 89%ile, Figure 3; (c) AI Halo effect now working in reverse —Momentum’s outsize moves this year were supported by FOMO in AI / LLM related trade that were expected to deliever productivity boosts for businesses almost immediately. During this earnings season, however, some of this enthusiam was partially corrected as revenue ramps from new services were pushed forward. The AI Halo effect is now working in reverse with LLM stocks on average down ~17% from their peaks; and (d) Positioning remains inconsistent with the cycle and recent risks —Investors are still not positioned for a softening macro backdrop with ample upside opportunity in Defensives ( Figure 6), Low Vol ( Figure 7) and Low Beta ( Figure 8). The current unwind has only partially corrected these extreme dislocations and far from completely mitigating the Momentum tail risk.
Tech momentum trades have only partially unwound, the team warn, meaning there’s plenty of trouble stored up if and when a real growth scare sparks another violent capitulation into “defensives, bond proxies and low vol”.
Historical analysis suggests a complete Momentum unwind—typical of full cycle resets—results in ~30% drawdown on average based on Long vs Short, cap-wtd sector neutral quintiles of S&P 500. This would imply the current rotation is only ~34% complete. However, we believe we are not yet at the end of the cycle, so expect only a partial unwind in Momentum and not a full flush, although we are gradually approaching towards it.
Vindication for Daddy Bear? US and Japanese stocks may have clawed back the bulk of their losses, but it’s clear that wherever he may be now, Kolanovic’s shadow continues to loom large over Wall Street…