Euphoria Fades From The Market, But Marko Kolanovic Doesn't Fade From His Forecast

One of the bigger or most obvious reasons the S&P 500 found difficulty breaking through and holding above resistance levels on Monday’s broad market rally was due to the bond market, the yield curve flattening to be more precise. I mentioned this aspect of investor sentiment recently as an impediment to investor sentiment and equities. Against the backdrop of a slowing global economy, trade skirmishes and rising rates, the yield curve’s slope as measured by the spread between short-dated and long-dated yields, are closing in on a so-called inversion. An inversion implies investors are selling short-dated bonds at a brisker pace than their long-dated counterparts. Bond prices rise as yields fall.

While I remain of the opinion, which is also the opinion of the Federal Reserve Chairman Jerome Powell, that a yield curve inversion isn’t likely the key recession signal that it has been in the past, the broader participating market still feels as though it is. When an inversion is triggered, this bond market indicator has been an accurate predictor of recessions, though the timing between an inversion and an economic downturn can vary from six months to as much as two years.

During Monday’s equity market rally the yield curve stole much of the trade truce headlines, as the spread between the 3-year Treasury and 5-year Treasury bond inverted. Except for the fact that this isn’t the inversion economists fear or even consider for recessionary signals, the inversion still found equity investors with increasing concern over the yield curve. Why? The last time the 3-year and the 5-year note inverted was back in 2007. That is also the same year that an inversion occurred between the more closely followed 2-year and 10-year Treasurys. And that’s the bigger issue for investors, analysts and economists alike, the current and extreme flattening of the 2-year and 10-year Treasury yield curve. It is the flattest it has been since 2007.

The reality is that even when the priority yield curve between the 2-year and 10-year Treasury yields invert, the market has historically risen over the next 12-month period. Take a look at the following historic chart from each of the last expansion cycles since the 1970s whereby the yield curve had inverted. (Table provided by Troy Bombardia)

As one can see, stocks tend to do well, even after the inversion. Trouble for the stock market tends to start AFTER the Fed stops hiking interest rates, due to a notable slowdown in the economy. At present, the Fed is still hiking rates and plans to do so in 2019.

I recently benefited from some of the disseminated notes of one my preferred market analysts, Marko Kolanovich of J.P. Morgan Chase. Back in November, Kolanovich offered his bullish thesis for the end of the year and during a time when markets were under severe pressure. See these notes below, which were delivered in Finom Group's research report titled (subscription needed) S&P 500 Met With Headwinds and Tailwinds This Week: Which Way? 

J.P. Morgan Quant Team Notes

As we’ve done throughout 2018 and when we believed it to be appropriate, we’ve offered some notes from various analysts and firms on Wall Street. One highly valued analyst team is that which is led by Marko Kolanovic of J.P. Morgan Chase’s quant team. In the most recent notes, Kolanovic and his team discuss their market outlook through year’s end.

  • Equities are close to triggering upside momentum signals, that could see CTAs re-lever and drive further market upside.
  • With fundamentals intact, fundamental and systematic investor positioning more supportive, buybacks strongly re-accelerating post-blackouts, and the market-positive midterm election outcome, we maintain that the recent sell-off is temporary and see further equity upside into year-end. In particular, we favor higher beta exposures and recommend positioning for upside into year-end.
  • We believe favorable and credible progress on the China trade war is more likely than not into year-end (i.e. ≥51% probability) as President Trump can no longer count on Congress or the Fed for economically supportive policies. However, the option market appears to be materially underpricing this probability.
  • Global Hedge Funds are significantly underperforming the market YTD (HFs down ~4% vs. the market up ~5% YTD through Wed), and their market exposure is below average after their sharp de-leveraging during the October sell-off. Moreover, YTD our Equity Strategy colleagues estimate that just 35% of active managers are beating their benchmarks YTD, a significant deterioration since mid-year (when ~45% were outperforming). As a result, we could be setting up for a year-end performance chase.

“The market has rallied ~8% from its Oct 29th intraday lows, as the exhaustion of systematic selling, reacceleration of buybacks once blackout windows passed for the bulk of companies, and more recently the removal of election tail risks allowed markets to find their footing. Meanwhile, US equity fundamentals remain resilient and corporate sentiment largely unchanged following 3Q earnings, in which ~77% of reporting companies beat EPS expectations and delivered strong 26% y/y growth. Meanwhile, dealer and systematic strategy positioning is now supportive.  

Dealer Gamma Positioning: As option positions got rolled to lower strikes and the market recovered from its lows, the S&P 500 gamma imbalance came down from a record put tilt in mid-Oct to a moderate call tilt now (Figure 1). This suggests dealers are likely close to flat or slightly long gamma, and their hedging activity is no longer boosting market volatility (as it was through most of October). Figure 2 below shows the gamma imbalance by spot levels, and suggests short option gamma hedging should remain a non-issue for the time being, as long as the market trades above ~2750. The shift in gamma hedging impact should allow market realized volatility to continue to decline from October’s spike.”

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