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Kolanovic Says Owning S&P 500 Is Marrying Yourself

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Chicago Bankroll   Sunday, 02/21/16 02:04:19 PM
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Kolanovic Says Owning S&P 500 Is Marrying Yourself to Momentum
By Dani Burger

Going long the benchmark gauge for American equities is risky and leaves investors vulnerable to reversals in momentum stocks, Internet companies and a handful of megacaps whose fate is intertwined with the dollar.

So says Marko Kolanovic, the JPMorgan Chase & Co. strategist whose analysis suggests owning a diversified set of equities priced cheaply relative to their assets is the way to beat the market in 2016. Among other things, the strategy lets you avoid being whipsawed by the U.S. dollar, which Kolanovic estimates has a 30 percent correlation to the Standard & Poor’s 500 Index.

Kolanovic, a derivatives analyst who generally tries to predict how quantitative funds will react to volatility, valuation and other market inputs, has argued that a bubble has formed in momentum assets such as U.S. software stocks, which tripled since 2009. Stuffed with companies like Facebook Inc., Amazon.com Inc., Netflix Inc. and Google parent Alphabet Inc., indexes favored by passive investors are too dangerous, he said.

“We are not excited about owning the S&P 500 as core exposure to risky assets,” he wrote Friday. “When it comes to macro drivers of equities, the S&P 500 may be trapped by the dollar: it can’t rally to new highs without USD (momentum sectors, FANGs, etc.), and at the same time the strong USD is capping any significant upside due to its negative impact on EPS.”

A U.S. recession, although still unlikely, is becoming more plausible with the odds of a bear market standing above 50 percent, according to Kolanovic. The best way to navigate both the bull and the bear? Kolanovic points to a diversification strategy, where risky value stocks are hedged with gold, cash and the VIX. It offers a better reward than holding the S&P 500 or government bonds, he said.

With oil, China woes and Federal Reserve uncertainty dominating investor sentiment this year, nearly $2 trillion of U.S. equity value has been erased since New Year’s. It’s hit growth stocks particularly hard -- a change of pace from 2015 when the shares outperformed their value brethren. The Russell 1000 Growth Index has plunged 7.2 percent this year, compared to a 6.8 percent loss for the Russell 1000 Value Index.
Gains in momentum stocks have also derailed. Expensive technology companies have come to dominate the list of worst-performing U.S. stocks this year, with declines stretching past 20 percent for Amazon.com and Netflix.

As losses mount, momentum stocks and the dollar are likely falling from their cyclical highs, Kolanovic wrote.

“The S&P 500 is capitalization weighted, has high momentum bias, is Internet heavy, and is implicitly long USD (when the USD is near historical highs),” Kolanovic wrote. “One of the reasons behind the positive correlation of the S&P 500 to USD is the high weight in Momentum and Low Volatility stocks in the index, and these stocks’ positive correlation to USD.”

That may mean a “mean reversion” is playing out now in the market. Momentum shares and the dollar soon will be outpaced by shares with low price to book ratios and companies with minimal dollar exposure. Those companies, which include multinationals, emerging markets, commodities and the energy industry, are near their cyclical lows, he said.

If we are indeed headed for recession, the conditions were fueled by central bank attempts to handle the global slowdown which only strengthened the dollar but worsened the commodity rout, Kolanovic said. Meanwhile, proposed regulations have triggered weakness in financials. Yet a U.S. recession can be avoided, he said, with the help of the Fed and OPEC.

“We believe that the Fed’s divergence from the ECB and BOJ triggered the USD rally, which indirectly worsened the commodity and emerging markets rout,” Kolanovic wrote. “A negative ‘global wealth effect’ resulted in a global bear market and put U.S. growth at risk. As many of the conditions leading to the current crisis were ‘self-inflicted’, they can likely be ‘undone’ and recession avoided.”


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