Death of Momentum Trade Is Bad News for S&P 500, Kolanovic Saysby
JPMorgan analyst sees bubble in assets that led since 2009
A mean reversion may be good news for emerging markets
This year’s upheaval in financial markets is the first step in a reordering among stocks, currencies and commodities that will probably leave large-cap U.S. equities underperforming, according to Marko Kolanovic, a strategist for JPMorgan Chase & Co.
A breakdown in momentum trades, where investors pile into assets that have recently gone up, sets the stage for reversal in things that became overvalued in the seven-year bull market, Kolanovic wrote. Shares in emerging markets, commodities and the energy industry are likely to start returning more than the U.S. dollar and the Standard & Poor’s 500 Index, he said.
Kolanovic, a derivatives analyst who generally tries to predict how quantitative funds will react in equity markets to volatility, valuation and other inputs, said a bubble has formed in momentum assets such as U.S. software stocks, which tripled since 2009. That may mean a “mean reversion” is playing out now in a market where more than $2 trillion of U.S. equity value has been erased since New Year’s.
“To stabilize equities one would need a strong catalyst such as the Fed turning significantly more dovish (or even launching another round of easing),” he wrote.
Gains in momentum shares have derailed as losses mount at the start of 2016. Such stocks, defined as the ones showing the biggest gains in the last six to 12 months, returned 32 percent in 2015, according to data compiled by Evercore ISI and Bloomberg. Within an exchange-traded fund tracking 101 momentum stocks, only five have risen since the beginning of the year.
Right now, an “unprecedented divergence” exists between low-volatility momentum assets and high-volatility value assets. As money piles into momentum and flees value, it “eventually increases the crash risk” for the former, he wrote.
Kolanovic shot to fame last year after he attributed the summer correction in the S&P 500 to robotic selling by quantitative investment funds tuned to volatility and price trends. Two days after the S&P 500 completed an 11 percent decline, he singled out quant funds such as trend-following commodity trading advisers, risk-parity funds and volatility managed strategies as “price intensive” and correctly predicted further drops for equities.
Kolanovic pointed to the same trend-following strategies as contributing to the “momentum bubble.” He also cited similarly aligned macro hedge fund bets, increasingly popular passive funds, and volatile yet less liquid value assets.
“We think that fundamentals were only one of the drivers, and that structural reasons played an equally important (or bigger) role in the creation of this relative performance bubble” in momentum, wrote Kolanovic in Thursday’s note. “We think S&P 500 momentum turning negative this year (after a six-year rally) may be the first step of the mean reversion we expect to play out later this year.”