Briefly despairing, Nomura’s Charlie McElligott on Tuesday morning wondered if it was possible that his call for a pullback in US equities out of Op-Ex wasn’t going to pan out.
At the time, the vol.-control universe served as an incremental source of demand, re-leveraging into a rising market, while leveraged funds (which added to shorts last week) perhaps served as “fodder for a squeeze”.
Although Peter Navarro did his best to drop a match on dry kindling, equities pushed higher. Still, “it’s only Tuesday”, I wrote. “There’s plenty of time for that call to play out”.
Fast forward to Thursday and we’ve seen the second meaningful selloff for equities in as many weeks.
Jitters around the possibility of renewed lockdowns in states where virus cases are multiplying conspired with incrementally bad news on the trade front to trigger a wipeout Wednesday.
As a reminder, the stage was set for wider ranges this week following the gamma drop-off after options expiry. In addition to that, McElligott last week noted that the impact of overwriters rolling options was set to evaporate, and also flagged approaching buyback blackouts around earnings as a potentially bearish factor. It’s also worth considering what the impact of quarter- and month-end fixed-weight rebalancing might be, given that stocks have outperformed bonds recently.
The point: when you have those kinds of setups where the technical backdrop leaves the market vulnerable to larger trading ranges (as the gamma “pin” loses some of its influence) and supportive flows (e.g., buybacks) fade into negative flow catalysts (in this case possible rebalancing out of stocks and into fixed income), it means that any selloff tied to macro “shock” catalysts has the potential to be amplified.
Both the virus story and the trade tensions count as macro shock catalysts, with the former obviously impacting the market more than the latter.
On Thursday, McElligott is back, and while I don’t know if it’s accurate to say he’s “relieved” that his call played out, he’s certainly keen to remind you that he did call it.
“Now that was how it was supposed to look all along”, he writes. “The ‘trade up into-, trade down out of-‘ the June serial options expiration phenomenon [is] finally kicking in”.
Charlie flags a 150-handle range in S&P futures from Tuesday highs “on what looked to be short-covering and chasing from leveraged” to the overnight lows “on estimated CTA deleveraging and flipping again outright ‘-28% Short'”.
On Wednesday, as things fell apart, I noted that we had probably moved below the dreaded gamma flip level, beyond which dealer hedging can exacerbate directional moves. McElligott discusses this on Thursday. To wit:
The aforementioned catalysts then grew particularly interesting due to the anticipated clustering this week of 1) the Dealer “gamma flip” level (from “long” to “short”) around the same 3050-3080 approximate location over the course of the week where too we expected 2) CTA deleveraging in the legacy S&P futures “+100% Long” signal, which triggered on the close below 3053 yesterday and was likely a large part of the flow on the trade down to 3005 overnight (the S&P signal is now “-28% Short” FWIW), both of which would act as “accelerant” flows on a move lower.
That, Charlie says, “dictat[ed] nearly $68 billion of selling in US Eq futures”.
So, where does that leave us going forward? Well, if we’re going by the analog, there’s good news (for bulls, that is).
“Due to the ferocity of this down-trade (-4.5% from Tuesday high to the overnight low), we have already achieved DOUBLE the median downside trade typically experienced for the 2w window post Op-Ex”, McElligott says.
From here, one-month, two-month, three-month, six-month, and 12-month median returns are generally bullish, with high hit rates historically.
The takeaway: the trade “sets up pretty bullishly for the next one- to two-months, McElligott writes, where that means equities higher with Tresaury yields.
He notes that this is “especially” achievable given that “clients have continued to voice a desire to ‘buy the dip’ into negative earnings revisions”, which is a positive for forward S&P returns.
And don’t forget the same lagged, mechanical re-leveraging from the vol-control universe mentioned above. He says that “could look like Variable Annuity ‘sell’ flows out of USTs and all with a fresh CTA ‘Equities Short’ base as fodder for a squeeze higher into any additional macro relief after this latest ‘wave 2’ swoon”.
That latter point will become important going forward I think. The market has a tendency to get impatient with “thorn-in-the-side” (if you will) macro issues, and then, eventually, risk assets learn to live with the uncertainty, comforted by the monetary policy backstop. We saw that with Brexit and with the trade war, and we could eventually see it with COVID case growth — assuming the health care system doesn’t buckle and fatalities remain low, of course.