Last week, Nomura’s Charlie McElligott outlined how, on the heels of the October equities rout, active managers found themselves in the rather unfortunate position of “literally low-ticking” their exposure just as systematic strats and macro funds began to re-risk.
Specifically, McElligott noted that last Monday saw “the largest underperformance in the top 10 ‘most crowded’ longs versus the S&P since 2010 on forced-deleveraging [with] both gross- and net- exposures at ~2Y lows, 5Y delta-adjusted gross just 25th %ile and 5Y delta-adjusted net at just 9th%ile.”
Subsequently, stocks staged their best two-day rally since February into month-end. From the Monday lows through the Friday highs, S&P futs rallied some 6%.
As noted, the systematic crowd was just waiting to re-risk following the October washout and on top of that, macro funds were sitting on some dry powder after going into last month on the right side of the trade (more on that latter point here). And so, CTAs jumped on the move higher, with Nomura’s Trend CTA model showing S&P positioning rising to +60% Long by Thursday from just +31% Long two days previous. As for macro funds, McElligott wrote that the surge higher for equities developed after the macro crowd took profits on downside hedges which, Charlie notes, “meant yards of equities delta to buy over 48 hours and [a] quick pivot into outright upside expressions through early December.”
Ultimately, McElligott thinks the Long/Short crowd was in part responsible for last week’s rallies. They are, Charlie contends, running a “massive synthetic short-gamma in the equities space.” With options expensive, those fundamental investors might have been forced to panic-grab S&P futs and ETFs in a hapless effort to not get left even further behind as the market rallies.
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Fast forward to Wednesday (i.e., to the early morning U.S. equity rally following the midterms) and McElligott is out reiterating his de facto short gamma thesis.
After noting that since the beginning of last month, his hedge fund L/S model witnessed “9 unique sessions of greater than 50bps of underperformance vs SPX out of a total of 27 trading days”, Charlie emphasizes that “this is not just a Hedge/Leveraged Fund observation, as Asset Managers have sold down ~$-91B between SPX-, NDX- and Russell- futures over the past month.” Here’s the breakdown on that:
(Nomura)
And here’s the cumulative position for asset managers in the S&P, big-cap tech and small-caps:
(Nomura)
McElligott goes on to explicitly reiterate his point from last week about the forced exposure grab:
As such, the “fundamental” active Equities universe then has essentially become a source of synthetic “short gamma” in the market, as with any rally in stocks, said performance-burned funds effectively “get short-er” the higher Equities travel…in-turn contributing to these violent bear-market rallies on “up” days, with funds grabbing exposure “dynamically hedging” futures on said move.
If you’ve been following along, you might be asking yourself what McElligott thinks about the prospect of Growth (and other consensus slow-flation plays) making a comeback in a scenario where the outcome of the midterms leads to a resumption of curve flattening (Wednesday initially saw the biggest flattening in the 2s10s since May). You’ll recall that in early October, the acute steepening episode that unfolded following a string of euphoric U.S. econ was what started the ball rolling on the Growth-to-Value rotation that ended up catalyzing the October 10 Momentum unwind.
On that point, Charlie says “the S&P has recently shown us that throughout the 2.5% MTD rally in minis that the market can work with Value leading [as] 4 of the S&Ps top 5 sectors so far in November are Materials, Industrials, Energy and Financials.”
He still thinks that a resumption of curve flattening will ultimately undermine the nascent Value trade (and, by extension, give some relief to recently-beleaguered Growth) – and that’s actually bullish for the broader market. With Value having performed well recently, but set to perhaps cool off helping Growth regain its footing, the stage is set for a scenario where “all parts of the market participate as exposure is rebuilt into year-end”, Charlie contends.
When taken together, all of the above leads McElligott to one conclusion:
Expect a broad based rally over the next month, as it is once again the course of “max pain.”
Three cheers for “max pain”!
