- Marko Kolanovic, JPMorgan’s global head of quantitative and derivatives strategy, thinks the recent spike in oil prices will accelerate the decline of one of the market’s most-loved trades.
- He also details how the rotation out of momentum stocks and into value stocks is similar to the short-volatility trade he correctly predicted would collapse in 2018.
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“History doesn’t repeat itself, but it often rhymes.” — Mark Twain
If you’re up on your financial markets history, you’re aware that investors often make similar mistakes on multiple occasions. After all, the four most dangerous words in investing are “it’s different this time” for a reason.
Now, Kolanovic sees trouble brewing for those who have been heavily reliant on one of the market’s most-popular and long-lasting trades: long-momentum, short-value. And to, add insult to injury, he thinks that the recent spike in oil prices will exacerbate the already-noticeable unwinding.
“These trades worked well until the rotation started, and now are in the early stages of a collapse,” Kolanovic wrote in a note to clients. “We believe the unwind is in its early stages, as evidenced by equity PMs continuing to fight the value rotation towards oil and natural gas sector every day last week.”
That last bit is important. The price of oil plays a key role in the long-momentum, short-value trade. It’s what everyone’s short, and why portfolio managers aren’t letting the price go down without a fight.
Kolanovic continued: “The recent shock in oil prices came amid significant crowding in short oil and gas futures by systematic and macro investors, even more extreme shorting of oil and natural gas exploration and production stocks by hedge fund pods and quants, and puzzling investor complacency towards geopolitical risks.”
Momentum has trounced value for years now, and has rewarded investors for simply buying what’s already going up, in a systematic fashion. All money managers had to do was simply set the trade, and forget it for an effortless windfall of profits. And, as you would imagine, positions became heavily skewed.
Unfortunately, this sort of methodology almost never works on Wall Street. Relationships between asset classes change, means revert, and new dynamics shift allocations into previously unloved portions of the market.
Today, that same set-it-and-forget it, autopilot mentality is coming back to bite investors — and it’s made its presence clear amidst a violent rotation out of momentum and into value.
Parallels to the doomed short-volatility trade
What’s more, Kolanovic has seen it all before. He draws parallels between the momentum-value unwind and the unceremonious collapse of the infamous VelocityShares Daily Inverse VIX Short-Term ETN, also known by its ticker of “XIV.”
Designed to provide single-day returns that were the inverse of the VIX — which itself is a measure of future volatility expectations known as the stock market’s “fear gauge” — XIV was essentially a short-volatility bet. And it was one of the most reliable trades around … until it suddenly wasn’t.
During its heyday, the short-volatility trade made many people a lot of money in a short amount of time. Perhaps the most high-profile example was former Target manager Seth M. Golden, who grew his net worth from $500,000 to $12 million in just five years going short VIX.
The short-volatility juggernaut was ultimately enabled by prolonged monetary easing that backstopped stocks and suppressed large price swings. It was such a reliable trade that many market participants got complacent and assumed it would last forever. But Kolanovic saw disaster brewing.
In early February 2018, when the Dow Jones industrial average recorded its biggest single-day point decline in history, the VIX spiked a record 84%. That effectively broke XIV and wiped out nearly $3 billion in value across multiple short-VIX products.
Kolanovic had been proven right. And now he’s he’s making a similarly ominous forecast about the momentum/value unwind.
“Crowding in this trade reached levels that will ultimately make it another XIV trade,” he said. “Recall that selling volatility was a trade that worked well for a long time.”
He continued: “The more money that went into selling volatility, the better it worked via direct suppression of implied volatility and feedback loop suppression of realized volatility … Investors were able to lever to levels that eventually led to a wipeout once forced closing started.”
While the long-momentum/short-value comeuppance is unlikely to strike as quickly as the short-volatility blowup, Kolanovic says a similar level of complacency has sent into the market — which is precisely when conditions get most dangerous.
He instead sees this reversal occurring in gradual fashion, and warns it’s already in progress. For those looking to get ahead of any further movement, these highly liquid factor ETFs would be ideal vessels for that:
- Momentum: iShares Edge MSCI USA Momentum Factor ETF (MTUM)
- Value: iShares Edge MSCI USA Valued Weighted ETF (VLUE)