From ‘We’re All Gonna Die’ To 15-Sigma ‘Hope’ Shocks (And Beyond)

Nothing is certain in life besides truisms, tautologies, death, and taxes, and even the latter needn’t be preordained, or at least not if what you’re talking about is “funding” government expenditures in advanced, currency-issuing economies with sufficient monetary sovereignty.

Unfortunately, we all die one day, but hopes for a safe and effective COVID vaccine decrease the odds that we’re all going to die tomorrow, and that, in turn, has ramifications not just for standard safe havens, but for market pricing across sectors and styles.

Monday and Tuesday of this week offered a rather dramatic glimpse into a hypothetical future defined by an end to the pandemic, a reflationary macro backdrop, and a concurrent unwind of what some argue is an almost unfathomable valuation disparity between perennial secular growth/bond proxy winners and cyclical value/high beta losers.

Read more: In This Market, ‘Good News Can Actually Lose You Money’

You’re reminded that while Monday’s record momentum unwind was unprecedented, “these things gotta happen every five months or so — ten months,” to adapt the famous Clemenza quote. “Helps to get rid of the bad blood.”

Some might remember what happened in early September of 2019, for example, when the snapback higher in yields following an August growth scare/convexity-flow-pile-on bond rally triggered a pretty dramatic factor quake.

“My long-standing view has been that the decade-long legacy cross-asset ‘everything duration’ trade will, by nature, always be at risk of positive growth/inflation impulses, with sharp lunges from bull-flattening into occasional (but violent) bear-steepening… corresponding with violent ‘Momentum’ factor unwinds inside thematic Equities,” Nomura’s Charlie McElligott wrote Thursday, three days on from Monday’s historic shock.

“This has happened a few times a year… and this time was no different, as it was pretty rational that a lunge from a ‘we’re all gonna die‘ pricing-in of future growth and [election] event-risk ‘worst case’…. towards a suddenly more optimistic view of the economic recovery thanks to the powerful ‘renormalization accelerant’ of the [Pfizer] trial data” would prompt an abrupt shock-down across the duration trade in all its various manifestations, McElligott added.

For what it’s worth, JPMorgan notes that Monday’s momentum drawdown was a 15-sigma event, which is just another way of saying it shouldn’t theoretically be possible.

So, where to now? That’s the question, and it depends at least in part on what kind of economic impact the US sees from the current COVID surge which, irrespective of your partisan affiliation, can only be described as totally out of control.

On the bright side, Goldman notes that “overall consumer activity has held up remarkably well thus far, with high-frequency indicators of consumer spending suggesting continued recovery through October.” The figure below illustrates the point.

However, the bank did caution that state-level data may begin to “foreshadow a slowdown in overall activity with a further rise in active cases and hospitalizations likely to come.”

This is juxtaposed with optimism around a Biden administration and, more importantly, vaccine news, as discussed at length Thursday in “Hope. But Also Fear.”

“Markets are forward discounting mechanisms, and right now, all the bad news is being ignored as investors instead focus on the encouraging vaccine headlines,” Kevin Muir, formerly head of equity derivatives at RBC Dominion and better known for his exploits as “The Macro Tourist,” said, in a Wednesday evening note to subscribers.

“Given this week’s monster move in value versus growth, I believe there is a good chance that a multi-year move has started,” he added. If that’s true, it’s long overdue.

Regardless of your view on the sustainability/durability of any pro-cyclical rotation that manages to “stick” beyond a few sessions, one point worth considering is that this kind of dispersion can tamp down index volatility, just as it did at various intervals over the summer when tech was blowing the doors off while laggards struggled to post even meager gains.

“One way in which these large moves (at the expense of certain other sectors) are having an impact is to exert pressure on the correlation between stocks”, SocGen’s Jitesh Kumar, Vincent Cassot, and Gaurav Tiwari wrote in August. One side effect was to push down realized index volatility. At the time, I wrote the following:

The flip side is that, in addition to the obvious impact on benchmark performance if/when the tech names which carry such heavy weightings finally decide to selloff, an aggravating factor could well be that such a move lower in the “titans” (as it were) would push up correlations if not met with enough outperformance from perennial laggards in cyclical value.

The question(s) implicit in that brief passage are likely to define 2021. As far as the near-term outlook, McElligott ties it all together.

“Now, in addition to the Op-Ex cycle being further supportive of Equities into next week from option dealer/vanna- and charm- flow perspective, you also have this ‘Value / Growth’ / ‘Cyclicals vs Seculars’ dispersion tailwind acting as a further vol suppressant on the index level because of a ‘netting effect’ as the divergent themes offset one another,” Charlie wrote Thursday.

If that does, in fact, serve to suppress index level realized volatility, it will feed into (indeed it will trigger) a latent, mechanical bid from vol-sensitive strats, as discussed here on Wednesday in “‘Sure,’ The World’s On Fire. But Strats Controlling $1 Trillion Will Still Buy Stocks.”

In turn, this could all play out into December and what McElligott notes is “year-end calendar bullish ‘risk-on’ seasonality.”

Assuming we get that calm window, enjoy it. Because January brings the Georgia runoffs, which will determine control of the US Senate and thereby the scope for Joe Biden’s agenda to be implemented — or not.