Who Will Be the Marginal Buyer?

The table below reflects an interesting analysis from JPMorgan’s head quant Marko Kolanovic. It shows how exposed different investor groups are to equities, relative to their own histories. Unfortunately, it’s not clear how far back this data goes, but there were a few comments that helped to define the time frame. For example, looking at U.S. Households, Mr. Kolanovic says that they are now in the 94th percentile in terms of total equity exposure (meaning that equity exposure has been lower 94% of the time), and that this is above the levels seen in 2007, and only slightly below those of 2000, so we know the data goes back at least to the tech bubble. In any event, the question this raises, is if all types of investors are near their maximum equity allocations, what does that mean for future demand for equities?

We believe that this analysis, taken as a whole, is yet another data point in support of reducing long-only equity risk in favor of hedged growth approaches, like long/short equity. While the economy is undoubtedly in good shape, and most economists and market strategists don’t see a recession until 2019 at the earliest, it’s important to remember that correlations between economic growth and stock market returns are quite low. The correlation between the quarterly change in GDP and the quarterly return to the S&P 500 has been a mere 0.06 going back to 1947.

Now granted, the stock market is a leading indicator, and so rather than measuring correlation on contemporaneous data, we should lag the GDP numbers on stock market returns. Doing so by 6 months does improve the correlation to 0.26, but extending that lagged period to 12 months has no meaningful effect (R=0.08), and further extending the lag to 24 months results in a slightly negative correlation of -0.07.

Point being, investors can’t take too much comfort in the fact that the economy is humming along. The market will likely suffer its next correction well before we have a recession. And with that investors need to take this time to assess the risks in their portfolios. Whether they are looking to reduce the risk of equity market volatility or searching for low correlation, this risk management needs to be in place prior to a correction.