The Illusion Of A Stock ‘Market’

So far, 2022 is a macro tragicomedy.

I’ve long suspected my penchant for describing various socioeconomic-market conjunctures as “fraught” would one day leave me bereft when things really took a turn for the worst. In 2020, when an existential public health crisis triggered the first real depression (with a “d”) most living people in advanced economies have ever witnessed, I figured I could safely describe the situation as “hopelessly fraught” without having to worry about wasting hyperbole I might need later, for some future calamity.

That’s a needlessly circuitous path to saying that during the early days of the pandemic, it was difficult to imagine things getting worse. Fast forward two years and things are unequivocally worse, or at least from a macro perspective.

While vaccines and therapeutics mean humanity is much better off on the public health front, the confluence of economic headwinds has arguably never been more onerous. Inflation in developed markets is as close to “out of control” as inflation gets in advanced economies. Central banks (sans Kuroda-san, anyway) are engaged in a panicked effort to reclaim their credibility, which in this case entails draconian policy tightening into a burgeoning growth slowdown. And, after countless dress rehearsals (including January of 2020, when #FranzFerdinand was trending on Twitter after the US assassinated Qassem Soleimani), something like World War III seems to have arrived.

Viewed through that lens, it’s a miracle (and not a small one, either) that US equities haven’t succumbed to a Jeremy Grantham-style collapse.

As I wrote these lines, stocks were poised for outsized gains on Wall Street. While it was tempting to cite Facebook’s earnings (after last quarter, the bar to clear was lowered to “not a catastrophe”) and a “bad news is good news” dynamic on the back of a negative GDP print in the US, the fact is, stocks are hostage to headlines, hedging and flows, which on most days combine to drown out the larger macro story.

“With all of this seeming macro calamity, US equities keep stabilizing off these ‘blasts’ higher, to the consternation of many with grossed-up short books and who are hedged for ‘FCI tightening, inflation, Ukraine and earnings disasters,” Nomura’s Charlie McElligott wrote Thursday.

On the earnings front, it’s the low bar story I alluded to above. There’s a sense in which things can’t get much worse for some high profile names which have suffered losses in the 40% to 60% range over the last six or so months. Additionally, headlines out of China suggest the Party is increasingly inclined to throw anything and everything at the economy as this year’s growth target slips away with each new lockdown announcement. Charlie summarized news flow from the past 48 hours:

Chinese MoF announced a cut to “zero” in coal import tariffs (to ease supply issues domestically); the State Council pledg[ed] to promote the growth of internet platforms and ‘tech innovation’ firms, while simultaneously pledging cash handouts to people who have lost their jobs; Xi advocat[ed] his ‘old reliable’ infrastructure push and credit-pumping; Shanghai COVID cases fell for a fifth consecutive day to a three-week low, eas[ing] the ‘China Shutdown’ panic.

Again, all of those stories are from the last 48 hours (give or take). I’d note that each and every one of them found expression in an all-caps Bloomberg alert (or multiple alerts). “The market” (whatever that means these days) sees those headlines and attempts to craft a coherent narrative, which in this case meant concluding that “Chinese authorities are pulling out all the stops to support economic growth and employment,” as McElligott put it.

Beyond that, he noted that “vol is back to softening and underperforming incrementally,” which has knock-on effects. These dynamics are still completely mysterious to the vast majority of market participants, to say nothing of financial journalists, which leaves virtually everyone grasping at straws while attempting to explain a given day’s price action. Here’s McElligott, with the real story:

These quick “Vol-melts” create “unemotional” second-order flows that might confound the fundamental world — where if Vol can now begin to sustain underperformance after its recent outperformance (admittedly not fully unshackled until after the Fed next week), it kicks off intermittent blasts of mechanical buying, either via Dealer “short hedges” being covered in options (as Puts bleed / are unwound and the associated biblically “Negative $Delta” gets bought back), while also seeing gradually softer Vol [take us closer to] reallocation and buying from Systematics, which remain significantly underallocated vs recent history.

Importantly (and I can’t emphasize this enough), you don’t have to understand every facet of modern market structure to grasp the overarching point. If it seems to you like equities careen wildly from day to day with almost no connection whatsoever to any sort of fundamental narrative or macro driver, this is why.

Volatility is mean reverting. At a certain point, the market can’t deliver the implied daily swings. When that tipping point is reached, vol tends to collapse under its own weight, at which point the above-mentioned second-order effects kick in like falling dominoes.

When traders load up on protection (especially short-dated protection) and the market moves against those positions, dealers cover their own hedges as spot rallies away from the strikes. That very act (buying back futures) turbocharges the rally, thereby amplifying the dynamic. The green diamond in the figure (above) shows you the dry kindling.

Meanwhile, as vol moves lower, systematic exposure is dialed back up. “In a world where ‘volatility is the exposure toggle,’ a trending-lower vol input will mean systematic reallocation flows for Target Vol and Risk Parity,” Charlie wrote Thursday. The figures (below) give you a sense of how much daylight there is to the upside from an exposure perspective.

As spot chops around through key trigger levels for CTAs, markets witness “bouts of covering in current and largely ‘short’ equities position signals,” McElligott went on to say.

This is why stocks are, during some weeks, scarcely worth covering. That’s a fatalistic take, and the point certainly isn’t to suggest there aren’t opportunities for the tactically-minded.

Rather, the point is just that efforts to ascribe causality on a daily basis that don’t make mention of these drivers are, at best, incomplete. At worst, they’re just stories told by journalists.

The fact is, stocks aren’t a reflection of anything during some sessions. Not the prevailing macro calamity, not earnings, not even policy expectations. Just pure, unadulterated flows and the faint whir of cooling fans and server farms.