How To Make Sense Of Stocks In Modern Markets

Earlier this month, at least one bank suggested dip-buying, as a strategy, failed following the worst month for US equities since the onset of the pandemic.

“Buying the dip has failed to be profitable this time,” BofA’s equity derivatives team wrote, in an October 5 note, as stocks looked poised to struggle amid a mounting list of macro headwinds.

The S&P’s fourth-longest streak without a 5% pullback in five decades was over, and predictably, the financial media jumped at the opportunity to pen click fodder questioning the resolve of retail investors, whose mettle was purportedly being tested anew.

Fast forward just 10 calendar days and stocks are on track for their best month since April (figure below).

Note that virtually nothing has changed on the macro front. Indeed, you could pretty easily argue that the storm clouds there are even more ominous than they were in September.

So, what’s the narrative now? Bloomberg pitched this on Friday afternoon: “Stock Bulls Battle Fed and Win With Resolve That Shocks Skeptics.” It’s a somewhat confused piece that suggests the rebound in equities is attributable to “the market” (an independent actor, apparently) defying the Fed, as “optimism around everything from corporate earnings to COVID-19 counts and seasonal market trends put a muzzle on central bank-obsessed skeptics.”

We weave ridiculous tales to entertain ourselves. Characterizing retail investors as “armies,” or the more derisive “hordes,” who always act in concert may have been more or less accurate vis-à-vis a handful of meme stocks earlier this year, and it’s certainly true that retail’s footprint grew in the wake of the pandemic as “unsophisticated” homegamers learned new skills, including how to weaponize gamma.

But the idea of retail investors as the barbarians from the opening scene of the film Gladiator — a motley crew capable of “assembling” to defend some hallowed ground or trend line — is patently ridiculous. To the extent market participants act in concert, it’s not in “defense” of anything, it’s just another manifestation of the same dynamics witnessed over and over again since 2009.

In reality, almost all investors have the same calculus. As Nomura’s Charlie McElligott put it in March of 2020, “we all operate under frameworks which allow for greater leverage deployment into trending markets, and conversely, dictate de-grossings into ‘VaR-events.'”

You might not use that terminology to describe your own decision calculus, but if you trade actively, I can assure you it’s applicable.

At the same time, we all have the same muscle memory and conditioning after a dozen years spent operating in what Deutsche Bank’s Aleksandar Kocic has called the “state of exception.”

“Through their communication with the markets central banks, and the Fed in particular, have become ‘good listeners’ with their decisions and actions made with markets’ consent,” he wrote, in January of 2018. “After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting,” he went on to say. “Not much of a choice, really.”

While editorializing around BofA’s contention that dip-buying was poised to fail following September’s setback, I reiterated the same general message. Part and parcel of the post-GFC muscle memory is the consistent reward on offer for buying on any sign of weakness and/or selling vol at the first opportunity. “That manifestation of classical conditioning optimizes around itself as traders attempt to front-run one another’s Pavlovian response function,” I wrote.

It’s extremely difficult for anyone involved to extricate themselves from this cycle. Policymakers ostensibly want to normalize, but that’s easier said than done. And it gets harder over time. As Kocic put it,

The Fed (and central banks in general) carries an implicit responsibility for orderly reemancipation of markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo – a permanent state of exception.

For market participants, fighting that is an exercise in futility. While it’s true that modern market structure makes things more fragile, it’s also conducive to prolonged periods of calm, facilitated by declining realized volatility, which begets mechanical allocation and the buildup of exposure. Trending markets pull in other systematic strategies, and so on, in a virtuous cycle.

I would note that, currently, things still feel a bit manic (figure below).

That suggests accelerant flows remain in play and that, more generally, we haven’t yet settled back into the kind of insulated conjuncture conducive to a steady, boring grind higher.

The point, though, is to emphasize that conceptualizing of “dip-buying” as a simplistic mantra or, relatedly, as a behavioral pattern that finds expression solely in buying stocks after a shallow pullback, is a mischaracterization.

Increasingly, attempts to “explain” equities without explicitly referencing i) the interplay between modern market structure and a dozen years of classical conditioning, and ii) how the muscle memory instilled since 2008 affects, and finds expression in, vol-sensitive, systematic strategies and mechanistic flows, are doomed to inadequacy.

No one should misconstrue that as a suggestion that fundamentals don’t matter or that technical analysis (in the classical sense) is viable. Fundamentals do matter and I will forever contend that technical analysis, considered as a “science” that’s separate and distinct from the role trend lines and various technical signals play in algorithmic trading, is largely useless.

Rather, what I wanted to (re)emphasize is that making sense of the market is becoming both harder and easier over time:

• Harder, because it’s no longer possible to spin a compelling narrative based solely on the notion that this or that discretionary cohort interpreted some fundamental input in a way that’s consistent with a given week’s price action
• But easier in the sense that if you’re willing to understand the concepts associated with modern market structure and their interaction with the post-GFC classical conditioning, you can more accurately explain (even predict) why markets behave the way they do

To his credit, Bloomberg’s Lu Wang, in the linked article above, does mention expiry. “Since option dealers buy and sell underlying stocks to keep a neutral position, the need to hedge decreases once options mature,” he wrote, on the way to paraphrasing McElligott. “The rollover this time would see market makers’ equity exposure to the S&P 500 drop off by 35%, removing some pressure on the market to stay in a range,” he wrote.

Below is the quote from Charlie (via an October 13 note) referenced in the Bloomberg piece:

Turning to Equities, Spooz are holding again ~ the 4350 strike, currently the third largest $Gamma on the board at $4.2B and hence, the stickiness (only surpassed $5.9B at 4300 and $5.1B at 4500)…but critically, 55% of the $Gamma at 4350 is set to run-off after this Friday’s expiration, and 35% of the overall consolidated SPX / SPY options $Gamma dropping-off broadly Friday as well = “you are free to move about the cabin” thereafter, in either direction, as Deltas are de-risked.

Remember: For most people, it’s the concepts that matter, not necessarily the math or the exact levels. More and more, I see regular folks paying exorbitant monthly rates for “services” and Substack letters that endeavor to help retail investors sort through the complexity. You don’t need those. You just need to have a feel for the concepts. Ironically in that regard, the likes of McElligott and JPMorgan’s Marko Kolanovic very often do a better job of communicating in layman’s terms than do public web portals and high-priced newsletters which purport to “simplify” things.

As for what I’ll call “traditional” analysis which relies heavily on top-down, macro considerations, cycle theory and, more generally, history, to draw conclusions and otherwise extract signals from the price action, I fear it’s likely to fall into complete disrepair, even as practitioners will occasionally hit a home run by happenstance.

The macro obviously matters — many of the dynamics discussed above can’t “trigger” (so to speak) without a catalyst, and there’s no catalyst like a macro catalyst. But, again, penning strategy pieces isn’t as straightforward as it was two decades ago.

“It’s not been a good year for us on the level of the S&P 500,” Morgan Stanley’s Mike Wilson said, in an interview with Bloomberg TV’s Jonathan Ferro this week. “And we own that.”

---