On Monday, we started our latest note profiling the latest bullish outlook by JPM quant Marko Kolanovic, titled “Kolanovic Qu(a)ntuples-Down On Bullish“, as follows:
It’s become like clockwork: any time the market gaps higher, JPM’s quant “Gandalf” is out with a new note “reminding” JPMorgan clients that now is the time to buy stocks.
And, as has been the case for much of the past two months, almost the very next day after Kolanovic advised JPM investors to “buy the dip”, the market tumbled with the slide continuing on Thursday after the Wednesday market closure, and again Friday, as Kolanovic’s latest sanguine outlook was promptly ignored by a market which found a new bogeyman to worry about, in this case the arrest of Huawei CFO Meng, nervous what it means for the China-US trade truce.
Amusingly, it is none other than Kolanovic who earlier this week said the G-20 outcome would confirm that the “pain trade is to the upside” when he, clearly, was not aware of the tangential developments involving the Huawei CFO arrest and upcoming extradition. But instead of simply admitting that, an understandable excuse which would explain why his latest bullish call has once again been a money-loser for anyone who followed it, Kolanovic instead disgresses into another bizarre tangent blaming “fake and real media”, and “foreign geopolitical adversaries” – so… Putin’s fault the market crashed? – to explain why it has repeatedly turned out that the pain trade was not to the upside:
Fake and real media, domestic political opposition, and foreign geopolitical adversaries welcomed these policies and the instability created in foreign relations, the business community, and financial markets. We hope that some of this negative impact can be reversed, based on the recent progress made at the G20. Trade resolution could provide a much needed boost to equity valuations in 2019.
True…. and the incarceration of Meng could lead to a crash in risk assets and a “much needed” renormalization of valuations, one which excludes some $15 trillion in central bank liquidity propping up asset prices.
In any case, while most of Marko’s recent bullish reports – which have come at a time when virtually all of his sellside strategist peers have turned partially (Goldman) or fully (SocGen, Morgan Stanley) bearish – have been published when the market is enjoying a green candle, or at least an uptick, we were somewhat surprised that the JPM quant issued his “2019 Outlook for Markets and Volatility” today, with the market is tumbling once more and not to far from YTD lows.
That said, we were not at all surprised that after five consecutive bullish reports (first on October 12, following the systematic puke, then one week later on Oct. 19, then again on Oct. 30 when stocks hit another recent lows, then once more on November 7 after the midterm elections, and most recently on December 3) Kolanovic was, drumroll, once again bullish, and today reveals that his year-end price target for the S&P is 3,100, which makes Kolanovic one of the more optimistic strategists.
While we have heard Marko’s bullish, if not so accurate, tune quite often over the past two months, here is his explanation why one year from now he expected the S&P to be some 450 points higher. In a nutshell, the JPM strategist does not share the growing skepticism that a recession will hit in 2019 – or even be priced in- as “the business cycle will not end in 2019”, a conclusion he reaches by looking at high frequency economic indicators, none of which hint at an imminent economic slowdown, while also assuming that fiscal stimulus – in China and Europe – will pick up next year even as monetary stimulus becomes a drag on growth as central bank balance sheet liquidity injections go into reverse for the first time since the financial crisis. To wit:
We base our market outlook on the view that the business cycle will not end in 2019. Historically, equity markets peak several months before a recession, and to assume that market already reached cycle highs would likely mean that the recession needs to start around now. This is, however, practically impossible given the strong consumer spending, strong PMIs, and growing corporate profits. For instance, the most recent (Q3) US earnings season demonstrated the highest EPS growth, and second highest revenue growth, since 2010. Another reason why we don’t think the cycle end is close is because we think fiscal measures will supplement or replace monetary policies, not just in the US but around the world. This process started in the US, is now taking place in China, and will move to Europe with perhaps a significant delay. Fiscal measures are needed to maintain the competitiveness of the corporate sector in an era of global trade protectionism (e.g., note the recent corporate tax cut in Canada) and to address populist tension (e.g., in Europe).
For these reasons, Kolanovic says that he is still overweight equities and underweight bonds:
For 2019, we forecast continued EPS growth at a rate of ~8% and a price target of 3100 on the S&P 500. Positive GDP and earnings are “reality,” which is currently starkly disconnected from equity sentiment, valuation, and positioning. Figure 1 shows 12M forward P/E estimates that recently dropped near five-year lows. Positioning in equities is also very low. Figure 2 shows our model equity holdings of discretionary hedge funds as well as systematic investors (insurance volatility targeting portfolios, CTAs, Risk Parity funds, etc.), which are currently near five-year lows.
As noted above, there is by now nothing surprising about Kolanovic being optimistic: it now appears that he will carry the bullish “the tap on the shoulder” he received about a year ago all the way to the bottom of the ocean even as his more fickle, if prudent, sellside peers reasses that it is more prudent to change course than hit the iceberg of central bank normalization head on, even if it means them losing credibility (and/or their bonus) in the process.
Where Kolanovic had some potentially useful information, was his discussion of why there has been “a disconnect between strong fundamentals and valuations/positioning, and what is driving it?” After all, once upon a time Kolanovic was best known for his objective, accurate analysis of precisely the kind of positioning that helped him make correct forecasts for a change, something which prompted financial websites to introduce him to the public’s attention and elevated his profile overnight.
Here’s his take:
While higher volatility that comes with less monetary support warrants somewhat lower equity valuations, lower risk positioning, higher equity volatility, and higher credit spreads, we think that the current divergence is simply too large. To some extent, we trace the disconnect between negative sentiment and macroeconomic reality to the reinforcing feedback loop of real and fake negative news.
Kolanovic then discusses market liquidity or the lack thereof, as a potential trigger for (downside) event risk:
With higher interest rates, there are also real structural risks that are significantly higher this year. The most prominent one is the decline of market liquidity, as provided by electronic market makers. Figure 3 shows S&P 500 futures market depth, which recently declined to all-time lows. Lower liquidity is largely a result of higher volatility and higher interest rates. In an environment of poor liquidity, any market move will be amplified, thus creating a positive feedback loop between volatility, liquidity, and the news cycle. In addition, there is rapid growth in both human and algorithmic trading activity based on headline news.
So far so good; what we find rather stunning, however, is what follows next because it amounts to a bizarre admission that the opinion of the head of Global Quantitative and Derivatives Strategy at the largest US bank has less of an impact on market sentiment than “specialized websites that mass produce a mix of real and fake news” and which “present somewhat credible but distorted coverage of sell-side financial research, mixed with geopolitical news, while tolerating hate speech in their website commentary section.” If we were Mr. Kolanovic we would be very perplexed by how it is possible that such an imbalance of power can exist, especially since while there may be a gun to one’s head to write bullish notes, there is certainly nobody forcing anyone, especially not some of the most influential strategists at the largest US bank to read any website they disagree with or don’t feel like reading… Perhaps a subtopic for his next note, then one in which he is told to septuple down on bullish with the S&P another 3-5% lower in a few weeks?
In any case, we digress. Here is Kolanovic explaining why it is almost, but not quite, Putin’s fault that the market refuses to comply with his cheerful outlook:
For instance, domestic political opposition may have an interest to paint a negative economic picture, individual market analysts gain more visibility and coverage with negative calls, and foreign adversaries amplify a negative news cycle in order to foster divisions and erode confidence in financial markets and the economy. For instance, there are specialized websites that mass produce a mix of real and fake news. Often these outlets will present somewhat credible but distorted coverage of sell-side financial research, mixed with geopolitical news, while tolerating hate speech in their website commentary section. If we add to this an increased number of algorithms that trade based on posts and headlines, the impact on price action and investor psychology can be significant.
Indeed it can, and as Kolanovic himself says, “an example of the negative impact of carefully timed news stories is the recent episode with the arrest of Huawei’s CFO during the market holiday overnight session, which disrupted futures trading.”
He is, of course, absolutely correct: and yet what confuses us is why Mr. Kolanovic, who is after all an “analyst”, and should be precluded from making sweeping, definitive statements such as the following “we think that the G20 meeting brought significant progress in the US-China relationship and should be positive for the market going into year-end” (which he made on Monday), failed to consider precisely this possibility; a possibility which we explicitly listed as highly possible, to wit:
As usual, the meticulously logical JPM quant assumes the same level of logical reasoning can be ascribed to the president, when a quick scroll through Trump’s tweets over the past two years reveals that this is a very risky assumption, especially if Trump believes that he needs an external distraction to redirect attention from his domestic problems which, we are confident, even Kolanovic would agree are only set to escalate with the upcoming publication of the final Mueller report.
Perhaps it was a hotline to the Kremlin, and Putin’s insight into what is going on that allowed purveyors of “specialized websites that mass produce a mix of real and fake news” to be somewhat more skeptical about the world, and unexpected events could adversely affect markets. Perhaps it was also the fault of “fake news” – and, naturally, Putin – that algos fail to realize that “the pain trade was to the upside” and instead slammed stocks with a vengeance?
And it’s not just Putin and fake news. According to Kolanovic, “the current US administration has also given more than enough material (e.g., tweets, etc.) to be exploited by these actors in order to create an environment of investment uncertainty (e.g., on issues of global trade, oil, business decisions of individual companies, etc.).”
How dreadful: imagine having to be a trader or analyst in a market in which the outcomes are not absolutely, positively assured ahead of time and where there is inexplicably an “environment of investment uncertainty on issues of global trade, oil, business decisions of individual companies.”
Here we feel Kolanovic’s pain: after all, how can an analyst possibly make a forecast about the future if the future is not 100% guaranteed.
* * *
Still, despite Kolanovic’s admission that the future may be unpredictable after all, and that “specialized websites that mass produce a mix of real and fake news” could have a greater impact on investment theses than, say, JPMorgan (with a market cap of $346 billion), he goes on to do just that: predict the future. And to exactly nobody’s surprise, it is rosy:
We believe that in 2019 we will see a convergence of good macro and stock fundamentals and equity prices that were negatively impacted by sentiment and deleveraging this year (hence our S&P 500 price target of 3100). We also think that market volatility will decline somewhat from current elevated levels. Last year’s median VIX level of ~10-11 increased to a median 14-15 this year (as we forecasted in our 2018 outlook). In 2019, we think the median VIX will be around 15-16. This may be realized as longer periods of the VIX at 12-13 and one or two bouts of volatility in a 15-25 range (similar to what we saw in Feb-Apr and Oct-Dec this year). When we look at the various fundamental time series that are correlated with the VIX (over 100 time series measuring growth, employment, confidence, housing, and inflation), we find that virtually all of them indicate that VIX should be materially lower than the current level of 21. These models indicate that the VIX should average ~15 and stay in a ~13-20 range.
And with the median sellside S&P forecast for 2019 at 3,090 (see table above) it is safe to say that Kolanovic has decided to pick the safe choice, and “add value” by going with the crowd. On the other hand, in light of his recent “performance”, investors may be far better suited to read what Kolanovic views as the risks to his outlook.
What are the market risks for 2019? While we think that the trade war with China will improve next year, there is still some residual risk coming from global trade frictions. There’s a similar situation with monetary policy and interest rate hikes, where we believe the Fed recently outlined a more reasonable stance. We believe that equity markets can absorb one or two more hikes, but could come under increasing pressure beyond that. Pressure from rates could be further felt in the housing sector, where we think that the impact of SALT deductions, if unmitigated by political agreement, may put significant pressure on the property market in the H2 2019. Given the outcome of US midterm elections, it is virtually certain that US political divisions will introduce additional market volatility in 2019.
Scenarios are many, and we will be closely watching the new relationship between the White House, Congress, and special prosecutor. We believe that EM economies and markets have turned the corner and that receding EM risks and low asset valuations will lead to outperformance of EM assets in 2019. Political issues in Europe will persist for a while, but in the end they have to be resolved in the best interest of all parties. For instance, Italy cannot fund itself without the ECB, and conversely the EU cannot exist without Italy. Negotiations and frictions are part of populist theatrics and will be used by politicians for self-promotion, often bringing everyone to the edge. Yet we believe that these new age populists do not have broad enough support or conviction to cause the type of disasters that we witnessed in the 20th century.
And with that we look forward to Gartman’s take of 2019… and of course Kolanovic’s next research report in which he advises JPMorgan’s clients to take the other side of the bank’s prop traders, and just keeping buying the fucking dip.
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