Nomura’s McElligott: ‘Second-Order Melt-Up’ Setup Still In Play

“Stocks are doing their thing”, Nomura’s Charlie McElligott wrote, on Wednesday morning.

By that, he means extending gains, with S&P futures now nearly 5% higher off the coronavirus lows. 10-year yields, meanwhile, remain essentially rangebound, capped on the upside by growth concerns and on the downside by the exhaustion of key factors which contributed to January’s bond rally.

For what it’s worth (and Charlie has crunched the numbers), there’s a strong seasonal this week. Here’s the breakdown from McElligott: “Feb 10-17th since 2010–RTY +2.7% with 100% hit rate, HSCEI +2.6% with 80% hit rate, DAX +2.2% with 90% hit rate, Eurostoxx +2.0% with 90% hit rate, SPX +1.8% with 100% hit rate”.

The thrust of McElligott’s Wednesday missive is to reiterate the potential for the “daisy chain, second-order, crash-up” scenario to play out into expiry.

“Markets throughout January and the final week of the month in particular… began to price in a lot of worst-case scenarios in both the coronavirus-related global growth scare and the Democratic party ‘push hard-left’ in primary polling”, McElligott wrote last week.

The accumulation of crash protection in equities set up a familiar dynamic, whereby, in the event those worst-case scenarios don’t pan out (either with respect to the primaries or the pandemic), the purging of those hedges can act as a “slingshot” catalyst for stocks to go higher.

Read more: The Daisy Chain, ‘Crash-Up’, Equity Slingshot Setup Is Back In Play

Revisiting this on Wednesday, McElligott writes that “despite seeing a BIG short-cover over the past three weeks from systematic players in VIX ‘roll-down’, we are now in a place where a lot of these ‘worst-case scenario’ hedges are increasingly likely to expire worthless”.

He attributes that to the continuation of the vaunted “Goldilocks” backdrop in the US economy, and the fact that the bar for additional Fed cuts is infinitely lower than the bar for hikes. Throw in the Fed’s commitment to preserving easy financial conditions by committing to repos through April and, let’s face it, the likelihood that T-Bill buying will eventually morph into coupon purchases (i.e., QE “proper”), and market participants just can’t seem to make the case for overweighting the coronavirus in their near-term decision calculus. Who can blame them? Fighting a liquidity-driven market is, at best, a Herculean task. At worst, it’s a fool’s errand.

Charlie also gives a nod to domestic politics and the apparent abatement of new coronavirus cases.

“[There’s a] seeming perception of improving Trump reelection odds as the Dems chop themselves up in [the] primaries and a dynamic with the coronavirus outbreak where deaths outside of Wuhan remain low”, he writes.

Read more: Markets Resilient, Blankfein Rants About Russians As Virus Lingers, Bernie Tops Polls

The bottom line is that there’s still enough “dry kindling” (if you will) scattered about in the form of decaying hedges, to accelerate a move higher for equities as expiry approaches and those positions have to be “puked”.

This is, of course, contingent on nothing coming along to derail things. To wit, from Charlie:

In light of the market making new highs against this substantial Dealer ‘crash’ being held against all the high-profile legacy LARGE S&P downside / VIX upside call wing trades going-through the market over the past months, at least part of this risk management ‘crash’ protection could then decay hard next week if we “keep calm” into expiration and risk a further “sling-shot” higher for Stocks on the unwind.

There’s at least one pseudo-caveat on Wednesday, though. McElligott notes that over the past week, desk flow suggests dealers are “increasingly getting short the ‘call Wing’ to clients”, who are likely looking to make sure they can capture their “fair” share of the upside in the event the market sprints ahead.

(Nomura)

In any event, don’t be surprised if equities do manage to make even higher highs over the next two weeks on even the slightest of positive news flow or, in the same vein, the simple absence of negative news.