Stocks May Enter ‘Prototypical Feedback Loop’

Systematic strats and the vol-control universe are “in motion” as 2022 gets underway, Nomura’s Charlie McElligott said Monday.

The fundamental / discretionary crowd may follow suit “on the new PNL turn into the new year, particularly after so much de-risking in December,” he added.

Recall that the spike in realized vol catalyzed by Omicron’s emergence and a concurrent hawkish Fed pivot triggered a fairly dramatic bout of de-risking from target vol and CTAs over a one-month period through mid-December (figure below, from last month).

That meant cleaner positioning and less dry kindling, and also set the stage for re-risking in the event vol ultimately receded.

Now, equities vol is “collaps[ing] under the weight of its own implied expectations… creat[ing] a mechanical bid to the market in a virtuous feedback loop,” McElligott wrote, in his first note of the new year.

Five-day SPX vol is just 3.2 vols versus nearly 28 at the end of November, he noted, with emphasis.

What does this mean from a flows perspective? Well, again, it means mechanical re-leveraging.

Specifically, Nomura’s model suggests vol control added more than $31 billion of US equities exposure over the past week (figure on the left, below), with more to come.

“As trailing rVol continues to mean revert, we expect to see ongoing substantial Vol Control buying of US Eq on SPX daily changes < 1.0% over the coming 1w, 2w and 1m horizons,” McElligott said.

CTAs have likewise been a source of demand. Charlie estimated more than $21 billion in exposure adds in global equities over the past week (figure on the right, above).

The proverbial cherry on the sundae finds everything (SPX, QQQ and small-caps) back in insulating long gamma territory thanks in part to the Pavlovian response function which dictated reflexive vol-selling and hedge monetization into last month’s mini-fireworks.

That matters, because as the gamma pin keeps things stable, the distribution of outcomes compresses, exerting downward pressure on realized vol, thereby triggering more mechanical exposure adds.

It is, McElligott said Monday, ‘the prototypical virtuous feedback loop’ in modern market structure.”