Thursday’s reversal in US equities was one “for the ages,” as one mainstream media outlet put it.
The reversal from the lows to the highs on the S&P was 194 points. The Tick index hit minus 1,900, only to shoot beyond 1,900 (in the other direction). As Bloomberg’s Lu Wang noted, “never before has the market experienced such extreme readings in both directions in one day.”
As discussed here at some length on Thursday evening, the stage was set for fireworks. “Profit-taking on downside expressions and an abundance of dry kindling certainly could’ve made for a combustible setup,” I mused.
On Friday, Nomura’s Charlie McElligott offered an in-depth assessment. Much as I did Thursday, he emphasized that the transformation of the UK “left-tail” into a “right-tail” via the first reports of a fiscal U-turn from Liz Truss was crucial.
“The impact of what is now today’s ‘official’ policy U-turn and sacking of the Chancellor kicked off a de facto ‘right-tail’ trade, as the pressure release valves being UK rates and FX which were the epicenter of this latest global markets shock over the past few weeks, were instead powerfully reversed,” he wrote. That “remov[ed] the catalyst behind the forced selling pressure of the pension liquidity clean-up, but also dictated stop-outs and unwinds of shorts who’d been exploiting the incoherent policy dysfunction” in the UK.
Nicely put. I attempted to communicate that point on Thursday evening, when I insisted that any account of Thursday’s dramatic reversal in US markets that didn’t include voluminous editorializing around events in the UK was incomplete. McElligott’s Friday editorializing around those events was indeed voluminous. In simple terms: Charlie doesn’t miss.
“As this UK episode sat at the core of the latest escalation of ‘macro vol’ in rates and FX, the reversal impact it had on global markets was tangible,” he wrote, noting that the sudden “impulse easing in financial conditions, with bonds and equities rallying in unison at the same time that the dollar was being smashed” constituted the “dead opposite of the year-to-date macro trend trades.”
Drilling down into the mechanics of the squeeze, pervasive underpositioning and extreme negative delta and short gamma within options due to legacy downside hedges, all acted as “fuel for a melt-up,” with the UK U-turn serving as the macro catalyst.
Here’s what happened next, recounted as only McElligott can:
In the “peak perversion” that makes markets so grotesquely beautiful, the US CPI print went “wrong-way” for risk, with another “hot inflation” upside surprise opening the door for that panic downside push in equities, as Fed terminal rate projections again exploded higher and added over a full new hike, pressing ever closer to 5% (hit 4.945 at highs, 4.865 last).
S&P futures gapped -3.7% in the one minute following the CPI release (!), as this fresh “worst-case-scenario” then hit, as puts picked-up delta / calls went deep OTM and dynamic hedgers pressed shorts in the hole to fresh two-year lows in S&P, coinciding with UST 10-year yields exploding to 14-year highs / UST two-year yields to 15-year highs.
BUT the gap lower in equities then saw the “new options muscle memory 1.0” kick in, with an almost immediate move to monetize downside / sell puts, as traders wisely refuse to get too greedy in a year of so few winners, and “lock-in” accumulated wins from said hedges instead.
And thereafter, in what I’d call “new options muscle memory 2.0,” traders then looked to exploit the impact that the closing / monetization of downside puts will have on spot markets then rallying (as dealers close “short hedges” and have to buy futures) by buying loads of fresh super-convex (highly sensitive to price / delta change) 0- and 1 days-to-expiration upside calls across single-name, ETF and Index.
That should all sound very familiar to regular readers. That’s what’s happening behind the scenes. Or behind the screens, if you like.
Ultimately, it’s a pretty straightforward dynamic. Stocks slide sharply, puts are monetized, calls are piled into and the result is a massive positive delta impulse. Thursday’s was $154.6 billion on Nomura’s estimates (figure below).
That’s a 96%ile event, and it was in no small part responsible for the near 6% surge off the lows over just six hours on Thursday.
“Naturally,” the dynamics in options spilled over into systematics, triggering buy-to-cover flows in US small-caps, for example, where a $10 billion “buy” impulse from CTA trend likely helped explain a 7% low-to-high reversal in Russell futures.
Going forward, the outlook is uncertain, to employ what feels like a woefully inadequate euphemism in light of head-spinning churn, both in markets and geopolitics. It’s also earnings season in the US, which is virtually guaranteed to introduce all manner of catalysts, both upside and downside (and maybe upside down too).
McElligott summed it up with one (long) question: “Will the YTD trader muscle memory of ‘monetize gap down days then reload fresh downside’ occur once again, after having just (at least temporarily) ‘solved-for’ a major point of systemic stress with the UK unfunded tax cut reversal, and into an EPS season which is looking eerily like Q2, which acted as launch-point for the big summer rally off horrible expectations which provided a ‘low bar’ to surpass?”
Good question(s).
The “McElligott Talks Options” genre of Report is among my favorite.
Definitely. It was notably absent this summer when he went on vacation.
I’m not an FX guy, but was the dollar well and truly “smashed?” Feel like the UK implosion took everyone’s eyes off farther East where the yen seems to have lost all grip and the yuan is now countenancing 7.25, notwithstanding their respective government’s grips. Also feels like the next 75 bp Fed hike just 2 weeks or so out will produce little immediate progress on the jobs and inflation front, while undesirably stirring up the FX beehive.
As Einhorn said in an interview on Bloomberg and I am paraphrasing nobody knows the value of anything anymore.
The range of MSFT suggested a perpetual change in annual cash flow of nearly $10Bn!!!
“Value” investing is rare it seems, it is all momo, quant, etc. Do people ever think in terms of competitive advantages, sustainable cash flows, balance sheets?
Is VaR really risk? Or does valuation really matter? The future cash flows from the business we are buying? YES, BUSINESS not pieces of paper that are priced every second.
I am guessing most of the people on this site are retail or former (retired) “pros”. This is a HUGE advantage in markets like these (both when the crazy upsides happen and when opportunity knocks). One does not need to “mark to market” or “closet index” or make decisions on “career risk”.
Valuation matters. Just because everyone else “plays the game” where “edge” is VERY limited and rarer than most think there is an advantage smart investors have.
When I am finding 5% FCF yields that can grow high single digit + over the next 3-7 years I will be buying them regardless of all the “noise” out there. The only thing that will make me lose money is poor analysis (the cash flows are not there or the world ends – which it then doesn’t really matter).
Be smart guys and take a step back and think of what you are buying and how much you are paying for it (like you do in most things in life).
Hopefully some day we get over this quant, meme, momo phase and go back to real security analysis. This only hurts the retail crowd.
It’s not a “phase.” This is modern market structure. You can’t expect dealers not to hedge their exposure. You can plead with investors not to day-trade options, but good luck on that. As for CTAs, they’re deeply embedded across every asset class on the planet in every locale. These are markets. What you’re describing is what markets used to be. That’s never coming back. You have to remember too that a lot of market making is totally electronic now. There are less actual people involved. And when volatility is high, market depth deteriorates commensurately, which leads to more volatility, and around we go. This is only going to get more acute going forward. There are no “markets” anymore.
In agreement. As so eloquently put in many of your articles about what is normal, just another example of the “new” normal.
I again learned a little about market functioning and volatility on this site. And (humbly) helps reminds me on a daily basis of how little I actually know. The only certainty is that nothing is certain (Pliny the Elder).
I started on the institutional buyside in the late 1990s, doing fundamental security analysis and valuation, and even 30 years ago markets were often manic-depressive and irrational from a fundamentalist’s POV.
Think back to the Tech Bubble, all the valuation shops that went out of business, and the Tech Bust, all the gro/mo shops that went out of business. Go further back in history, same story, tulips and South Sea Island shares and so on.
Market prices have always had a fundamental core, overlaid and often dominated by stuff not found in Graham & Dodd. There’s more of that “stuff”today, and different stuff too.
After all, fundamentally driven active discretionary investing in cash equities is a very small percentage of total trading volume including derivatives, index, and ETF volume.
Well, there are many positions to play in this game, and any of them can be successful over time, if the player is good, controls risk, and resists the temptation to suddenly jump to playing a different position. You know, if you’re struggling at wide receiver, it’s probably not going to help to switch to defensive end.
I think ultimately you have to find the kind of investing that you enjoy.
As for the dealer hedging, day trading, CTAs, etc, I think their influence on price (but maybe not volatility) decreases rapidly as the investment horizon extends. I don’t have any data for that.
H
The fact that Thursday happened on a bad news day implies that what you just said in your comment is that there are no “markets” anymore. As you point out, everything has to be hedged somehow these days, everywhere. Even the hedges are hedged, insured, or otherwise protected. Actual securities are well camouflaged in our current financial structure so nobody really knows what’s about to happen on any given day. The “market” feels a bit like a jack-in-the-box that changes its tune at random every day. It can be exciting … I guess.
The U.K. political system would benefit from an intense study of Plato’s republic. Especially the ship analogy and the philosopher king. I despair being a Brit.
The solution for a fundamental investor is to do the homework as described above from oldschoolvalueguy but to avoid big down or up days to enter or exit and to extend your time horizon so that valuations do matter. On a day to day or quarter to quarter those things won’t matter- but over a longer period those approaches can bear fruit. That is the advantage that long term investing has.
After all the fireworks were over, one thing remained the same: macro is still in the driver’s seat. U.S. consumers are still feeling flush (or liquid? same thing in 2022?), generationally high inflation persists, and the Fed sees the combination as an opportunity to normalize rates. (Which it is.) The bottom for the equity indexes is not yet in.
Good commentary. The more esoteric securities are predictive of the the more transparent ones. And broker dealers that aren’t making money are less effective ant providing liquitidy. So Charlie M’s clients are seen to be more important. What is harder to figure out and innoculate against are the new time bombs masquerading as securities that are not understood and therefore not hedged. It will always be thus.
H-Man, we are chasing the flows of a slow moving glacier. Ultimately, the glacier melts over time until there is nothing to wash into the sea. And then the glacier is reborn.
‘monetize gap down days then reload fresh downside’
Actually, yes, that sounds like me.
Although I didn’t do as well as I would have liked on the ‘monetize’ part. I was waiting for a certain profit target and then we got the rug pull. I wasn’t paying enough attention to option flows.
I don’t know how else to say it. You do want to be positioned short in this market. The money printing machine has been working overtime for many years. Now all that is coming undone.
The correct position is short. But everyone knows that, and that’s the problem. If everyone is on one side of the boat, then the boat tips over.
“Although I didn’t do as well as I would have liked on the ‘monetize’ part.”
Well, it’s like one of my father’s friends told me about stop signs when I was learning to drive on an old stick shift in a tiny little town that only recently got its first Starbucks: “You can’t catch ’em all.”
Come on,,, it’s a bear market so something will trigger a short covering rally I survived 1969/70 and 1973/74 bear markets which had equally sharp rallies and reversals…and there was no liquid options market back then and certainly no stock futures…McElligott is terrific but he might as well have said more buyers thank sellers…until we get capitulation the bear will continue on..likely to 3,000