Markets continued their wild ride on Wednesday, as US equities surged, ostensibly on Joe Biden’s strong Super Tuesday performance. Things were helped along by news that Republicans and Democrats came to terms on an ~$8 billion emergency spending bill (embedded in full below) to fund the government’s response to the COVID-19 outbreak.
To be sure, investors are relieved to see the odds on the Democratic nomination swing dramatically back in favor of a centrist – a “status quo” candidate, as it were. The word “revolution” doesn’t generally go over well with markets, unless it’s accompanied by a supply-side policy platform complete with tax cuts and promises of across-the-board deregulation.
In a hypothetical Biden vs. Trump general election, there is arguably no real “bad” outcome for markets, or at least not from the perspective of near-term policy changes with the potential to trigger a dramatic de-rating in equities.
(SocGen)
Additionally, it’s possible that markets will be comforted by the prospect of a Biden presidency to the extent it would mean more predictable outcomes (compared to Trump). That goes double in the event investors get the idea that it will be difficult or impossible for Trump to do much more in terms of cutting corporate America’s tax bill, etc.
“A centrist democratic president would likely be neutral to net positive for the market… based on our estimate that the benefit of reduced macro volatility (trade wars, market volatility, uncertainty for businesses/capex, etc.) likely more than offsets the potential increase of corporate and individual tax rates”, JPMorgan’s Marko Kolanovic wrote Wednesday, in a short note reiterating points he discussed at greater length in December.
Read more: Marko Kolanovic Predicted Trump’s Election Win. Here’s What He Thinks About 2020
Of course, the swings in markets last week and this week are being intensified by systematic flows and hedging – that’s at play again on Wednesday as discussed here.
Clearly, Tuesday’s post-Fed-cut rout was down to profit-taking from Monday’s gains which, as you’re probably aware, were turbocharged into the close by the very same dynamics that have acted as accelerants since options expiry last month.
“We see [Tuesday’s] sell-off post-Fed as technical and a result of the strong Monday performance driven by an S&P 500 option gamma squeeze into the close”, Kolanovic went on to say Wednesday, adding that “after the initial decline, significant selling from S&P 500 option gamma hedging, volatility targeting selling (given the large Monday realized move), and some CTA selling below the 200-day MA pushed the market lower (similar size as Monday’s buying)”.
It’s important to remember that all of this is being exacerbated even further by a veritable collapse in market depth, which is itself part of the feedback loop that puts us in environments like we’re in now.
As discussed here at length on Sunday, liquidity vanished during last week’s rout. The following visual shows you the average number of contracts at the tightest bid/ask in E-minis.
(JPMorgan)
As you can see over there on the right-hand side, this simple measure of market depth fell rapidly to near record lows, in line with December 2018. What stands out the most about that visual is that market depth has never recovered from “Vol-pocalypse.”
When it comes to how and why modern market swoons sometimes seem to “snowball” and “cascade”, Kolanovic’s colleague Nikolaos Panigirtzoglou wrote of CTAs that “momentum traders were caught with very long US equity futures positions into the correction and were forced to unwind these positions abruptly, propagating their own negative momentum“.
All of this works in the opposite direction, too, something I try to emphasize, although the point often falls on deaf ears, as fear “sells” better than “hope”.
When market depth is impaired, large buy flows magnify upside moves. During the final week of December 2018 (the worst December for US equities since the Great Depression) a massive surge was catalyzed by rebalancing flows, as equities were bought and bonds sold given the extreme monthly performance disparity between the two. Then, as now, liquidity was sparse.
Taking a trip down memory lane, recall that on Thursday, December 27, 2018, we saw the biggest reversal for the S&P since 2010 and a concurrent selloff in bonds.
(Bloomberg)
It was accompanied by what, at the time, was the fourth-highest print on the NYSE tick index of the entire bull market:
(Bloomberg)
So, when market depth is impaired, systematic flows, rebalancing from fixed-weight portfolios, and other various “buy” impulses amplify the upside just as deleveraging into a thin market amplifies downside moves.
Just to give you an “apples-to-apples” comparison, last week witnessed one of the lowest prints of the bull market on the same NYSE tick index.
“The price impact of [this week’s] flows [was] magnified by the record-low market liquidity”, Kolanovic said Wednesday, noting that since the beginning of the COVID-19 panic, there’s been a ~90% plunge in futures market depth.
He also underscores the point made here earlier about the vol.-targeting universe having now deleveraged to the point where there simply isn’t much to sell.
“Our estimate of volatility targeting equity positioning is now in the ~5th historical percentile [so] there is relatively little further to be sold [and] trend-following equity exposure is estimated to be in ~25th percentile”, he remarks.
As ever (and this is becoming repetitive, but you should get used to it, because it’s going to be the caveat/disclaimer/fine print on every, single piece of analysis you read for the foreseeable future), everything now hinges to a great extent on the evolution of the virus.
As Marko puts it, “the main downside risk is a prolonged paralysis of economic activity”.
Eight billions seems paltry compared to the trillions lost at the margin. 200 billion would be noticed
As a frustrated R I will gladly take an adult President Biden with rational thinking and stability over the childlike (age 3) trump. Confidence in a Biden admin could add several mult points to stocks while biz invest would grow offset by slightly higher taxes.
I will gladly take that.