The Infallible Dip-Buyers

The latest swoon for US equities proved to be another opportunity.

Once again, investors’ classical conditioning was reinforced. Pavlov lives.

The S&P logged its second best week of 2021 on the way to new highs (simple figure below), despite sparse information on the Omicron variant and no indication whatsoever that the Fed will be dissuaded from announcing an accelerated taper pace at next week’s meeting.

“The case to accelerate tapering is strong; after all, it becomes a moot point if monetary policymakers wait until Q1,” BMO’s Ian Lyngen and Ben Jeffery wrote. “Technically, January would still be relevant, but the recent economic data has provided more than sufficient cover for the Committee to follow through on the recent hawkish pivot and thereby cement investor’s renewed confidence in the Fed’s willingness and ability to combat higher consumer prices,” they added.

Although November CPI came in red-hot, as expected, it could have been worse. Indeed, The White House’s communications strategy (i.e., Thursday’s preparatory damage control) convinced many that the numbers would be considerably worse than consensus. That the annual prints merely matched expectations was a relief for markets, if not for the public. If the situation was “urgent” from the Fed’s perspective, the November data didn’t make it any more urgent, which was about all anyone could ask for.

It’s worth reiterating that the two-week losing streak which preceded this week’s rally was exacerbated by thin liquidity, positioning and the proximity of year-end. Simply put, the market wasn’t prepared to cope with foreboding headlines about yet another more transmissible COVID variant coming out of the Thanksgiving holiday in the US.

The curve was already predisposed to shouting about policy errors, and the combination of Omicron and Jerome Powell’s abandonment of the “transitory” description of inflation made things worse. It was a perfect storm. Now, it’s subsided, even as daily swings are still disconcertingly large (figure below).

That could entail additional lagged de-leveraging from some vol-control cohorts, although that’s just me doing some off-the-cuff weekend musing.

On December 6, Goldman’s Rocky Fishman reminded investors that the interplay between thin markets and systematic selling can be pernicious. “Weakened S&P futures liquidity can exacerbate the impact of any systematic equity selling,” Fishman remarked, adding that Goldman doubted managed vol funds had de-risked materially. “Current levels of realized volatility are only marginally higher than they were as markets started to slide in the final days of September, and the funds had not de-risked by [then],” he wrote. My sense is that vol control indeed cut exposure over the past three weeks, but as ever, it depends on how wide you cast your net when you define target vol. And also how you model it.

Speaking of Goldman, Christian Mueller-Glissmann suggested large stock corrections are “unlikely” in the near-term, provided growth stays a semblance of robust and real yields continue to make the “TINA” case.

“Given the speed of the growth re-pricing, our Risk Appetite Indicator fell sharply into negative territory, reaching -1.2 at the trough, largely driven by a spike in equity volatility and widening credit spreads after a year of strong resilience,” he said, before underscoring the notion that recent fireworks may have been at least as much noise as signal. “The ‘risk-off’ moves across other pro-cyclical assets such as cyclical versus defensive and US 10-year breakevens has been more contained, indicating that positioning unwinds and illiquidity might have exacerbated moves.”

Although Mueller-Glissmann said earlier this week that the bank’s RAI needed to fall further in order to present market participants with a truly compelling opportunity, he was more constructive in a note dated Friday.

“Typically, the signal to add risk based on our RAI alone is stronger at lower levels (below -1.5) and with most components declining sharply,” he wrote, recapping brief remarks to Bloomberg. The caveat is that assuming sentiment around the trajectory of the economy holds up and financial conditions stay accommodative, risk appetite typically rebounds quickly.

That’s “especially” true in cases when setbacks “are due to temporary growth shocks, such as the new Omicron variant in this case, rather than broader concerns about the cycle,” he went on to say.

So, what’s the takeaway?

Well, one possible interpretation is just that while concerns around Omicron are obviously warranted, the “initial market reaction… probably overshot,” Goldman said, on the way to suggesting that “slightly better” news about the variant and the apparent onset of a Chinese easing cycle helped turn the tide on sentiment this week.

After reiterating that “the risk of being temporarily stuck in a ‘fat and flat’ range increases in the case of growth decelerating with inflation rising and continued Fed tightening,” Mueller-Glissmann wrote that “large equity corrections appear unlikely as long as the mix of growth and real yields remains favorable and smaller ones might continue to offer ‘buy the dip’ opportunities.”

One more time: Pavlov lives.