There’s no imminent risk of the dominoes tipping to trigger the kind of nasty, self-fulfilling technical selloff in equities that’s become an all-too-familiar occurrence over the past several years, but that doesn’t mean everyone should be totally complacent.
That’s one takeaway from the latest by Goldman’s Rocky Fishman, who, in a note dated Tuesday, reminds folks that “the equity market has shifted from low-vol rallies to sharp sell-offs several times over the last two years”, which means it’s necessary to “continue to monitor conditions that could exacerbate a sudden” rout.
For anyone who needs a reminder, those conditions include, but are not limited to, market depth, the proximity of key trigger points for trend-following strats and dealer gamma positioning, with the latter being particularly instructive if you’re looking to explain big intraday swings (see: “All Of This Summer’s Big Daily Stock Moves Had One Thing In Common“).
(SocGen)
As far as market depth goes, Goldman’s Fishman notes that “SPX futures liquidity has stabilized… but the interplay of semi-algorithmic systematic macro strategy rebalancing and 2018-9’s weakened liquidity conditions remain a concern”.
That’s a reference to the feedback loop that can develop when automated de-leveraging collides with a lack of market depth to drive up volatility, thus exacerbating the situation in a self-feeding loop. The visuals below show that while market depth has strengthened (left pane), it hasn’t improved “as much as the low VIX would indicate it should”, to quote Fishman.
(Goldman)
The recent rally has not been accompanied by new lows in implied vol. – Fishman points to call appetite. “The SPX has returned over 6% since its early October low a month ago [and] while the VIX has been low, it has failed to drop below 2019’s low of 12, in part because of call-buying to chase the rally”, he writes, adding that “falling short-dated skew is further evidence of this”.
He goes into a bit more detail just for good measure, noting that every new peak on the S&P has generally been accompanied by a higher VIX, suggesting “the floor in SPX implied volatility has been drifting up”.
“The VIX was close to 13 when it crossed 3075, above its level when most new highs were set over the last three years”, he notes.
(Goldman)
In all likelihood, that trend will continue going forward given the bevy of event risk, mostly centered around potential geopolitical land mines, but also capturing possible year-end funding stress which continues to cause daily hand-wringing for those who believe another bout of tightness in short-term funding markets could escape from the lab (as it were) and spill over into asset prices.
Ultimately, Fishman says he does “not see heightened risk of a technicals-led selloff in the near term”, but suggests “hedging is still timely”.
After all, he writes, “cutting equity risk via 1-month 25-delta puts has outperformed cutting an equivalent amount of delta-one risk” over the past three years. He also says a simple stock replacement strategy might not be a terrible idea, especially across the pond, where implied vol. is parked near its lowest levels in years.
