‘Was That It?’: Bearish Psyche Versus The Right Tail

It could be an afterthought by the end of the week depending on how patient rates are with what was almost guaranteed to be yet another scorching read on US inflation, but as of Wednesday afternoon, equities looked a semblance of sure-footed.

Stability is something stocks haven’t seen a lot of in 2022. Lest we forget, the S&P suffered its worst 16-session start to a calendar year in history. (Define: Inauspicious.)

If it’s an unabashedly bullish take you’re after, confirmation bias will be difficult to come by. At the same time, overtly bearish forecasts were ironically blunted by January’s correction. Indeed, you might even suggest bears were caught wrong-footed by the very selloff they predicted.

“[Our] S&P target was achieved in week three; were we wrong or early?”, BofA’s Savita Subramanian wondered. “Elements of our too bearish call last year are playing out today.”

That was late last month. It was another way of asking, “Was that it?”

Most strategists would say “no.” There’s nothing especially cathartic about a 10% move lower after one of the most spectacular rallies in a century (figure below).

Ultimately, the market is gripped by the kind of cognitive dissonance that sets in when everyone wants to be cautious based on a seemingly bulletproof fundamental bear case, but at the same time fears a scenario where the market runs away to the upside, as it so often has in recent years.

This is captured in the options space. “SPX Skew and Put Skew continue to get mushed, while Call Skew maintains a substantial relative bid as recent client deleveraging has accounts increasingly concerned about missing ‘right tail’ despite being bearish in psyche,” Nomura’s Charlie McElligott said.

“The selloff in equities has taken a breather, VIX has normalized and measures of SPX volatility skew and convexity have declined in recent weeks even as fixed income markets are pricing a 50bps hike in March and five 25bps hikes by end of year,” Barclays’ Maneesh Deshpande remarked, in his latest.

He continued, noting that “hedgers appear to have monetized their protection and have not rolled.”

Importantly, positioning is now much cleaner, where “cleaner” is perhaps better described as “cleaned out.” Hedge fund nets are just ~38%ile. And Nomura’s model suggests vol control’s stock allocation sits in just the 20th%ile, while CTAs’ equity exposure is an outlier-ish ~4th%ile (figure on the left, below).

Meanwhile, Tuesday’s moderately constructive session pushed dealer positioning back towards long gamma territory. Even getting back to neutral would be a welcome development, as it would help anchor spot, mitigating the extent to which every day is a roller coaster.

Remember, gamma is the cornerstone. “We’re close to adding the ultimate ‘Vol compressor’ to the backdrop for the S&P 500,” McElligott went on to say Wednesday, referencing SPX’s approach to the neutral gamma line. “That means prior ‘accelerant’ hedging flows which helped create overshoots in both directions [are] now closer to… a position which is supplying liquidity, further neutraliz[ing] volatility through less erratic price action,” he added.

Again, this is still very tenuous. Indeed, that’s the point. Modern market structure is self-referential at every turn. Stability is needed to promote more stability, and eventually, stability breeds instability. Once the dominoes tip, it can take a while for equities to reestablish the virtuous feedback loop.

“Stocks were making a lot of progress in that regard, right up until January’s CPI report” — is what we may all be saying by the end of the week.