This is a “precarious time for bears,” Nomura’s Charlie McElligott said Tuesday, as calls for a bear market rally grew louder, even as the recession choir sang on.
The simple case for a (possibly fleeting) bounce in beleaguered stocks centers on the notion that sentiment extremes are good contrarian indicators and sentiment is extremely poor.
A more nuanced, technical assessment takes us through familiar dynamics as OpEx looms.
“There is just massive ‘short $Delta’ from associated demand for legacy downside hedges,” McElligott wrote, adding that lower implied vol is “having a profound effect on highly-convex expiring puts, which are decaying rapidly, incentivizing the closing-out of ‘bleeding’ options, which then means dealers are covering huge amounts of ‘short hedges’ in futures against the puts they were short, further boosting the rally in spot.”
From there, the script writes itself. That’s dry kindling. If someone drops a match on it, a towering, bullish inferno can ensue, as the domino effect kicks in.
As stocks rally and hedges are monetized, vol recedes, which Charlie noted “helps the dealer gamma position get ‘less short.'” That, in turn, helps stabilize the market.
In the second act, vol-sensitive cohorts re-allocate to stocks mechanically. And there’s quite a bit of room for re-risking. On Nomura’s model, the target vol universe’s equity exposure ranks in just the 4th%ile, for example. That cohort could add some $27 billion in exposure over the next two weeks if the S&P were to settle and the daily distribution of outcomes compress to +/- 0.5%.
Additionally, CTA “buy-to-cover” trigger levels (from current extreme bearish signals) are within range.
Of course, the consensus is that there’s only so far stocks can run before the Fed becomes uncomfortable with the read-through for financial conditions, which absolutely must keep tightening.
McElligott called this a “be careful what you wish for” scenario. Stock rallies and tighter credit spreads “conjure an easing of financial conditions,” he wrote, adding that any rally in commodities on the back of expectations for China to begin relaxing COVID measures in Shanghai would add to central banks’ inflation concerns.
“This goes back to my observation since the Fed’s December regime pivot,” McElligott said. “Rallies in risk assets dictate… escalat[ions] in hawkish signaling in order to push back on easing FCI, which is counterproductive to their ‘demand-killing’ price objectives.”
Writing late last week, in a note called “Ride of the ‘Volkyries,'” Zoltan Pozsar said “the Fed is now in the business of writing a call option on risk assets — not just stocks, but housing and crypto as well.”
“Whether we think of the FOMC’s target level for the stock market and financial conditions as a call option or still as a put option just with a lower strike price is semantics,” Pozsar added.
Buy the current dip, then sell the big rip and later buy the deeper dip, in the vortex of a probable recession, easy.
All the algos and AI need to be updated: don’t fight the Fed when the Fed is trying not to fight.
I first just chuckled when I read your post, but after some pondering, I tracked it down. It’s a good point. The better algos keep morphing as past relationships no longer seem to hold. Dynamic modeling! Well the Fed has made a 180 degree change here. The models will have to catch up. Eventually they will, as they “unlearn” what they “learned” before.
Static risk control/vol parity models will quietly lose investors and close down eventually. It’ll be interesting to see how long this takes.
Never wrong, often early
Opportunity to adjust exposure to where one would like it to be for the rest of the bear market.