‘Frenetic’

US equities have refused to break down entirely despite macro events continuing to conspire against stocks.

Anecdotally, I’ve waited for weeks on something that looks like a capitulatory purge, only to be disappointed, although I’m not sure that’s the right word. The point is just that as bad as 2022 has most assuredly been, there hasn’t yet been a day when it felt like US shares truly gave up the ghost.

It could be there’s just not a lot of scope for additional de-risking from key investor cohorts, even as the market remains in VaR-down mode. In a Friday note, Nomura’s Charlie McElligott cited “chronic underpositioning” from both hedge funds and systematic investors, both of which are “de facto ‘short’ alongside historically high cash levels,” he said, on the way to calling equities sentiment “horrific.” The bank’s sentiment indicator sits in just the 16th%ile (figure below).

Obviously, the list of factors weighing on investor psychology is long, and includes worries that would sound comically bad if it were possible to laugh in the face of human tragedy and acute suffering. There’s a pandemic and a war, both of which are inextricably bound up with the highest inflation in four decades across Western economies. It doesn’t get much worse than that.

McElligott went on to call the S&P’s relative resilience on Thursday “remarkable” given flows associated with a big unwind in the options space. The index never really broke down, he said, noting that 4,200 “continues to hold.”

“The S&P 4200 put floor has been such an incredibly strong support level with $3.8B Gamma there, the largest of any strike by far,” Charlie noted, adding that 4300 has been a “pretty solid overhead resistance over the past week, so the ‘range trade’ remains intact, even if you expand it out to 4400.”

Effectively, market participants large and small are day-trading options in a headline-driven environment, which Charlie aptly described as “frenetic.”

It’s self-fulfilling and, more importantly in this case, self-referential (those aren’t necessarily the same thing). “Short-dated puts are by and large ‘working’ and convex,” McElligott wrote, noting that this “perpetuat[es] the persistent dealer ‘short gamma’ / ‘short delta’ dynamic.” Of course, that dynamic itself exacerbates the price action, with the potential to sap liquidity and market depth, thereby amplifying the effect of the same flows (or any flows, really).

However, downside is monetized quickly at the first sign of a rally, and as spot moves higher, OTM puts bleed out, triggering a bullish cascade as everyone covers short hedges, leading directly to huge squeezes (like what we witnessed Wednesday). Immediately thereafter, though, “what keeps happening is that these rallies are either being de-grossed into and/or traders [are] back reloading their downside or buying puts by end of day,” as McElligott wrote Friday.

At some point, if rallies are to sustain themselves, upside needs to be fueled by something other than the “dry kindling” dynamic detailed above. That is, folks need to start playing offense or, as Charlie put it, “actually taking shots on upside.” There was some good news on that front Thursday, but according to Nomura, “next week’s OpEx is the real opportunity to see a more sustained equities rally, because all of that downside loaded into on Fed FCI tightening and Ukraine escalation is at real risk of decaying into expiration.”

Hope for a “dovish” hike. And pray for a de-escalation in Ukraine.