The ongoing compression of realized volatility into a rally that saw US equities push to new records last week has catalyzed mechanical re-leveraging from vol-sensitive investor cohorts.
That’s tautological. If volatility dictates your level of exposure, then you’ll dial things up in lagged fashion as trailing realized falls. And vice versa.
“Our model estimates vol-control buying of another $16.8 billion over the past one week and now $25.7 billion over the past two-week period,” Nomura’s Charlie McElligott said Tuesday, noting that even with this added exposure, “overall implied Equities allocation remains just 27.8%ile [on a] 10-year lookback, so [there’s] certainly capacity to add more.”
This has been (and continues to be) an important part of the post-election, year-end, melt-up thesis, although you might argue (as Charlie does) that the market would need another shove in the direction of a new low vol regime to get much more “oomph” out of this particular impulse.
While not every measure of sentiment points to euphoria, Nomura’s gauge is “foaming at the mouth,” McElligott wrote, noting that it closed in the 98.9%ile since 2004 on Monday.
If you’re wondering what typically happens following those kind of overshoots, a backtest shows nosebleed readings skew one- and two-week forward returns “slightly negative” for the S&P.
“Investor sentiment continue[s] to improve, supported by renewed optimism on a US fiscal package deal,” Goldman said Monday. “Our GS Risk Appetite Indicator moved clearly in positive territory,” the bank added, noting the risk-on environment continues “despite recent weak economic data on both sides of the Atlantic.”
From where McElligott is sitting, “sentiment overshoot” is one of the sole “credible sources of potential pullback risk for the next two weeks.”
In other words, outside of the notion that things have simply run out ahead of themselves, the backdrop isn’t necessarily conducive to a serious swoon in the near-term.
Why? Well, because, as McElligott reiterates, “the ‘right-tail’ CRASH-UP scenario remains very much the more likely ‘play’ due to bullish/supportive options flow dynamics into Quad Witch Op-Ex and VIX expiry.”
Oh, and if you’re wondering about the potential for the Reddit crowd and the Robinhood’ers (who are apparently “furious” after getting locked out on Monday) to create another late-August/early-September setup, Charlie reminds you that retail is now acutely self-aware.
“I’m telling you, this is a real thing,” he said, adding that “the Retail hordes on Reddit/WSB [are] intentionally creating negative convexity events for Dealers in short-dated, out-of-the-money upside Calls in these single-name high-flyers.”
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