Still Shouting ‘Selloff!’

Folks keep warning about an imminent selloff in equities, mostly because that’s what folks do.

I’ve been adamant that many strategists’ frameworks are hopelessly antiquated vis-à-vis modern markets, but forgetting that for a moment, it’s not exactly as if traditional analysis and fundamental inputs are all screaming “Sell!” in unison.

Even where they are (screaming “Sell!”), the spin changes depending on whether a given analyst is trying to pound a square peg into a round hole as time decay accelerates on year-end targets with virtually no chance of being any semblance of accurate.

For example, it’s amusing to juxtapose what strategists say about stretched valuations when they need to add a kicker to a note calling for a pullback with what some of the very same analysts say when they’re penning a strategy piece suggesting the current rally has “room to run.”

In the latter case, clients are reminded that trying to call the top based on valuations alone is usually a fool’s errand. In the former, investors are told that “in addition to the foregoing, valuations are currently elevated on most metrics.” (That’s not a direct quote, but it could be.)

Right now, there’s more than a little concern about a hawkish pivot from central banks and what it entails for “priced-to-perfection” stocks. “We think it’s only a matter of time before equities are forced to price in the increasingly unfavorable policy environment for a market addicted to central bank liquidity,” BofA wrote, in a Tuesday note, flagging the disparity between equity and rates vol (figure below).

We know rising rates can pose a threat to equities, especially if the rapidity of rate rise is extreme. But even as the rush to price in preemptive rate hikes at the front-end is cause for consternation to the extent central banks revoke the market’s license to co-author the policy script, the long-end rebellion (i.e., falling yields) helps keep financial conditions easy, as do deeply negative real rates. The market won’t relinquish its policy consultant role willingly.

Morgan Stanley’s Mike Wilson who, after correctly predicting the post-pandemic trajectory for equities, found himself waiting for an index-level de-rating that never really panned out despite any number of corrections and pullbacks across sectors, styles and thematic trades, now says “the fundamental picture for stocks is deteriorating as the Fed starts to tighten monetary policy and earnings growth slows further into next year, turning outright negative for some companies.”

Goldman doesn’t agree with any of that. There’s no alternative to stocks considering how low bond yields are, Christian Mueller-Glissmann said. Crucially, he noted that stocks can stay buoyant provided short-end spasms don’t migrate to the long-end. That’s another way of saying what I described above about the rush to price in rate hikes at the front-end versus the back-end rebellion.

Time and again, though, it comes back to the same thing: You have to appreciate the dynamics associated with modern market structure.

On Tuesday, Nomura’s Charlie McElligott called equities a “clown car.” “We are fully immersed back in a ‘Max Long Gamma, Long Delta’ US Index options regime that will make it almost impossible for us to pull back,” he said, citing a “powerful resumption of large options selling and overwriting.”

Crucially considering the outsized influence of mega-tech on benchmarks, McElligott flagged unprecedented extremes in QQQ options. “Microsoft, Apple, Amazon, Tesla, Alphabet, Meta and Nvidia are at 26.41% of SPY and those same stocks are 50.76% of QQQ, so it matters a whole heck of a lot when we see QQQ options posting $Gamma and $Delta [in the] 100%ile,” he wrote.

Between that and i) the dramatic re-allocation from the vol control universe, where the lagged repositioning flow into equities summed to nearly $56 billion over the past two weeks on Nomura’s model, and ii) CTA exposure to global equities being dialed up by some $59 billion over the past month, you can begin to understand why equities generally ignored any and all “noise” lately.

Those stats (from McElligott on Tuesday) once again underscore my steadfast contention that if making predictions is hard, especially about the future (as the old adage goes), it’s impossible without taking the time and effort to appreciate the role of systematic strats and mechanistic flows.

Most analysts simply don’t appreciate those dynamics or, if they do, don’t assign enough weight to them. And, so, their nuance-free calls don’t pan out. If you’re not going to do as McElligott does (where that means obsessively tracking the dynamics that actually dictate daily price action), you’re better off just coming out in January and saying stocks will likely return at least 7% over the next 12 months. In most years, you’ll be right.

As far as when equities are likely to exhibit some jumpiness, the answer is pretty simple really. Stocks will get interesting again if there’s a shock-down catalyst that drives spot through key “flip” and/or “trigger” levels or, barring that, sometime around the monthly Op-Ex cycle.