Charlie McElligott’s spidey sense is tingling.
US equities and volatility rose simultaneously for two consecutive sessions this week, a development that may indicate a nascent sea change in investor psychology.
Since the selloff began late last year, traders marked a transition from a “buy the dip” mindset to a “sell the rip” mentality, which meant spot rallies were eventually greeted “with large ‘negative delta’ flows” as calls were monetized and market participants reloaded downside for a trade, “ensuring a bear-market-rally-fade” dynamic, McElligott wrote Thursday.
That might be changing. “In this most recent rally… we instead see call vols / skew staying very firm” suggesting investors may believe “this rally is ‘different’,” Charlie said. “Upside is not being faded or monetized,” he added, on the way to flagging evidence of client demand for “actual hedging,” where the operative word is “actual.”
In essence, McElligott said top-down conviction in the idea that earnings season will be defined by misses and guidedowns is at risk of being wrong-footed. Corporate profits may be the next shoe to drop, but there’s no guarantee it drops now.
“The top-down macro world expects this earnings season’s messiness and ensuing negative revisions to drive the next leg lower for risk-assets, but bottoms-up guys know that much of the surprising ‘in-aggregate’ positive earnings revision YTD is about inflation in commodities-centric industries,” he said, on the way to suggesting Microsoft holds the keys.
“Say MSFT reports earnings next week which, yes, are weaker and sees the stock trade lower after hours” but aren’t “end of the world” numbers, McElligott wrote, sketching a possible rally catalyst. If, by the following morning, PMs decide the numbers are fine, and that assessment leads to dip-buying, it could be a catalyst for the broader market.
I’d note, quickly, that Microsoft’s hiring slowdown is now a fixture of the financial news cycle. Press reports of job cuts at the tech giant started in May and haven’t let up since. That’ll be a focal point when the company reports.
“People are going to have a problem I think if MSFT is fine next week,” a client told Charlie.
What would happen in that scenario? Well, for one thing, any substantial move higher in spot could dictate further buying (or further covering) from CTA trend, which recently added more than $33 billion across global equity futures in the space of a week, on Nomura’s estimates.
The table (above) shows the levels beyond which CTA covering/buying could accelerate.
From there, things could get very interesting. “We’d have CTA trend buying [and] fundamental folks who missed the rally screaming to de-gross shorts and add longs [to] get their ‘nets’ up,” Charlie said, adding that if the timing is right, that could overlap with with a re-allocation from the vol control crowd. On that latter point, recall that three-month realized is likely to recede in the weeks ahead as a handful of large daily S&P moves from late April and May fall out of the sample.
With positioning very light, a scenario that finds stocks sprinting higher in a compressed time frame would surely prompt panic-buying — the “It’s running away from me!” scare would kick in.
McElligott called all of that the “‘yikes’ equities rally pain trade scenario.” Do note: It has a very short shelf life. Charlie’s medium-term view, informed by the realities of “sticky” inflation, is cautious.
The “worst equities outcome of all [is] a prolonged period of data-dependent policy uncertainty which leads to further extension of a choppy, sideways range-trade for the next six months,” he remarked.
