JPMorgan's quant guru diagnoses the market's brutal month of selling - and explains why stocks will surge into year-end

CNBC

• JPMorgan's global head of quantitative and derivatives strategy, Marko Kolanovic, performs an autopsy on the stock market's brutal October.
• Kolanovic also explains why he's bullish heading into year-end, and breaks down the positive impact a trade war resolution could have on equities.

The stock market's brutal month has left investors searching for answers.

Dip-buying sentiment has all but evaporated, seemingly unassailable profit growth has looked vulnerable, trade tensions have flared, and the prospect of tighter lending conditions has investors braced for slower growth.

It's all combined to make for a thoroughly uncomfortable market environment - one where a rebound can just be a head fake ahead of the next round of selling.

JPMorgan's quant guru, Marko Kolanovic - a man whose opinion is valued so highly that it can move markets - has been on the case. He diagnosed the recent gyrations in a recent note to clients.

Kolanovic attributed the first leg down in October to roughly $150 billion of technical selling - the kind triggered by quantitative models that get stretched out of their comfort zones. Then, after that part was complete, he says stocks were dragged lower by hedge fund de-risking and tech selling.

This hedge fund capitulation lowered their net exposure from near record highs in September to the lowest level since 2015.

Kolanovic also finds that, on the heels of the stock market's worst one-month return in more than nine years, asset managers who recalibrate their holdings on a monthly basis are the most underweight on equities since February 2009.

This would appear to be a prudent, defensive approach, assuming the selling pressure continues. But Kolanovic has other ideas. For one, he's more optimistic than most on the prospect of a trade resolution - progress that would calm investor nerves and perhaps spur stock gains.

Ultimately, Kolanovic is bullish into year-end, which could spell trouble for these risk-averse money managers. And he surmises that as they flip their weightings back into bullish territory, it'll help push the market up even further.

"With investors positioned defensively, and leverage rapdily coming out of the system, there is an elevated risk of market reversion into year-end," said Kolanovic. "Investors should keep this risk in mind - namely that an October 'rolling bear market' turns into a 'rolling squeeze higher' into year-end."

Kolanovic estimates that the squeeze could contribute 1-2% to equity index levels. Beyond that, he's hopeful that share buybacks - which have regularly underpinned the nearly 10-year bull market - will help save the day once again.

Further, Kolanovic expects volatility to decline heading into year-end. He estimates that calmer waters will lead systematic investors to pile roughly $100 billion back into stocks. And, as previously mentioned, he's holding out hope for a trade war de-escalation.

"Any progress on trade could result in discretionary inflows, reduction of current elevated short positioning, and year-end performance chase," he said.