“The S&P is stuck in no man’s land”, Nomura’s Charlie McElligott writes, describing a situation that finds spot loitering right around the “flip” line for dealer gamma positioning, meandering between two large strikes.
Reinforcing this aimless roaming at gamma/delta neutral levels is relatively meager CTA positioning, with McElligott flagging “low gross exposure levels due to the recent signal chopping back and forth [and] somewhat distant buy-/sell- triggers in either direction”.
With spot straddling the gamma flip threshold and the next sell level for CTAs all the way down at 2,746 (while the closest buy level is up at 2,936), stocks are left to float in purgatory, which isn’t the worst thing considering recent events.
So, what’s next? Where to from here for US equities?
For McElligott, the answer is “lower across the summer months”. Or at least that’s his “sense” right now.
He cites what he characterizes as the market’s “current pragmatism towards the virus in conjunction with the ‘feel-good’ of the rally leaving it exposed to the downside of a coming second-wave of cases”.
Obviously, easing lockdown protocols and reopening the economy will likely mean more infections and more deaths, something Donald Trump acknowledged in a series of somewhat tone-deaf remarks on Tuesday evening.
“Some states [are] rush[ing] back to ‘normalcy'”, McElligott writes, adding that if there is a second wave, there are “fewer Fed and fiscal bullets in the chamber next time around”.
As far as the virtuous dynamics that trigger systematic re-leveraging, the train (which wasn’t going that fast anyway, at least as it relates to the vol.-targeting crowd) is losing steam. It’s not (necessarily) a matter of the systematic universe de-leveraging, but rather what Charlie calls a “demand vacuum”, based on the technical setup required to trigger more buying.
“In order to make the allocation to equities grow again significantly, we would need to see 3m realized vol (~60) fall below 1m realized (~40)”, he says. In short, we need a serious bullish catalyst, and the balance of news this week seems to point in the opposite direction.
As far as seasonals go, Charlie reminds you they’re “weak-ish” or “mehh” for the summer.
“Gold and USTs trade strong, while May through September is bad for EEM and US equities themes [and] Duration Sensitives/Mo Longs tend to strongly outperform versus Cyclicals/Mo Shorts”, he notes, before delivering a crucial checklist of factors that helped drive the rebound off the March bear market lows.
The following is a fantastic summary, and speaks to my steadfast view that when you think about why equities were able to stage what, by most accounts, is the swiftest/sharpest bounce following an outright calamity on record, you absolutely have to take a holistic view, and avoid references to any one controlling factor or “proximate cause”, as it were. Here’s McElligott (visuals derived from Nomura’s QIS models):
- The ‘get constructive again’ starter kit established in March / early April: Massive monpol and fiscal pol response–CHECK / flatten the curve in US cases–CHECK / commencement of reopening on global and US state & local level–CHECK / positive phase 1 Remdesivir data, or comments from REGN yesterday saying COVID19 antibody could be ready by Fall–CHECK
- What this meant then too and occurring simultaneously was a set of further positive inputs into the “vol normalization” process, following the various “short vol” stop-outs in late March—by late April we’d seen the return of Overwriters into “expensive” vols, while too we saw the resumption of an upwardly-sloping front-end of the VIX curve as an “all-clear” signal for the return of systematic “Short Vol” & VIX roll-down strategies
- This then began to create mechanical covering of either legacy shorts (CTAs) or re-leveraging into longs from “vol control” / “tgt vol” space—and over the 1m stretch, at one point last week when the CTA signal had flipped back to “+100% Long,” we estimated ~$50B of CTA buying across US Eq futs on the month-long gradual / partial cover (from prior -100% position)…
- … while too our Vol Control model estimated ~ $15B bot over the past 2wks, as realized trailing vols reset gradually lower
Now, all of that is fading into the rearview as stocks drift into the summer.
That’s an issue, because with all the blood thus squeezed from the stone, the market could be bereft of tailwinds at a time when earnings revisions are likely to deteriorate further and macro realities begin to set in.
It’s important to note that here, “macro realities” means something different than, say, single-digit PMIs, which are basically just novelties for traders to marvel at. And it even means something different than horrendous unemployment data which, while truly tragic, has lost its ability to shock traders, even as it conveys despair on Main Street.
Rather, in this context “macro realities” means bankruptcies and credit events plastered all over the front page. Charlie describes it as follows:
An ugly forecast revision period for corporate EPS; data continues to come-in even worse than expected as consumer psychology remains altered; the corporate cashflow disruption and imminent bankruptcy realities become front page daily news (particularly anticipating bloodshed in the energy space); and 2nd order white collar layoffs in corporate America all contribute to another sentiment swoon.
Note that so far, that kind of dire news flow has been absent, even as everyone is fully apprised of the body blow the economy has suffered.
Commenting on this, Goldman notes that “the US paycheck protection program covers eight weeks of payroll and other costs for firms with up to 500 employees, which is too short if business remains impaired after May”. If one travels up the line, the bank frets that “support programs generally become even patchier, especially for high-yield or middle market firms that don’t benefit from the Fed’s and ECB’s corporate bond support programs”.
That’s not to say Goldman thinks Fed and fiscal support will be ineffective. In fact, the bank thinks the hit to personal and corporate incomes will be cushioned materially, almost the point of a complete offset, depending on what you’re measuring.
But the bank says it’ll be important to “carefully monitor trends in business financial distress and specifically bankruptcies”.
“So far, the deterioration in the US remains limited”, Goldman said Monday, before noting that while we’ve seen “an uptick in April”, it’s still “very early”.
The good news, from McElligott, is that once the “summer fade” is in the books, there’s scope for a “risk-on pivot”.
“The analogs and seasonals show a much more constructive environment beginning late in September through December, which also corroborates with various… macro regime change analogs”, he writes, referencing a series of notes from early April that looked at recent extremes in factor and style performance in a historical context in order to help forecast returns. The figure depicts one of those exercises, although there were several (for more on the conditions that fed into the analysis behind the chart below, see here):
The bottom line, from McElligott’s point of view, is that there’s scope for a “strong risk environment” six months out, and possibly accelerating thereafter.
This “post-recession trade” would need an improvement in the macro (e.g., an inflection in PMIs later this year) and would obviously be delayed or derailed by any kind of dramatically bad outcome that finds the US and China escalating tensions and/or a worse-than-expected second wave of the virus.
And don’t forget: There’s an election in November. Or at least there’s one scheduled.