Don’t say it wasn’t predictable. Because it damn sure was.
No, this isn’t another “I told you so” article. I wrote one of those first thing Wednesday morning much to the chagrin, I’m sure, of the crowd who couldn’t decide which Mideast outcome was worse: A “take the win and go home” strategy or a “Donald Trump broke it, so Donald Trump’s gotta own it” approach.
“Take the w” would save lives and rescue equities, but it’d mean Trump wriggling out of another jam of his own making. “Take the W.” (upper case, middle initial) would cost lives and further undermine risk sentiment, but it’d torpedo Republicans’ mid-term chances like a bad day for the IRIS Dena.
So, Trump critics were torn between hoping for i) a deescalation in the interest of lives saved and stock losses recouped, or ii) an Iran land invasion which, although very bad for lives and portfolios, would’ve been a possible death knell for Trump’s political career.
I took the “controversial” view that I’d rather Trump pull up stakes, even if that meant unfinished business and even if that’d give him six months to recover politically, thereby reducing the odds of the GOP getting Fidesz’d in November. I’d rather save lives and recoup equity losses than save American democracy, I suppose.
Ultimately, Trump did indeed decide to take the “w,” not the “W.” And if you ask me, that’s a win for everybody. It’s certainly a win for anyone who bought the dip in US equities, which were on the brink of a new all-time high mid-week.
The figures below, from Nomura’s Charlie McElligott, give you a sense of how the market’s perception of this situation has shifted.
As the annotation notes (and I can only assume the “nuke” pun was unintended), the inversion in the volatility term structure’s been figuratively “nuked out” over the last week as the odds of Iran being literally nuked out fell.
“All this ‘escalate to de-escalate’ motion has ultimately led to an eye-watering repricing in US equities volatility,” McElligott said Wednesday, noting that the “extreme” rally in spot is in part a function of the vol crush.
Those dynamics are just as familiar as Trump’s “escalate to de-escalate” act.
“‘Buyers are higher,’ as I like to say,” Charlie went on. “The ‘calamity premium’ is coming unglued and downside hedges [are] bleed[ing] out their Greeks as we rally away from strikes, while the prior steep skew flattens as a function of the ‘scramble into upside.'”
The annotated figures below give you a sense of what this looks like and, importantly, where it’s most acute (i.e., in the Mag7).
For the uninitiated, the red arrow in the upper-left-hand pane shows relative demand for downside protection versus upside optionality evaporating, while the red arrow in the lower-right-hand pane shows demand for crash hedges (i.e., OTM versus near-the-money puts) fading. The green arrow in the bottom-left-hand chart is the “grab” for upside exposure.
“First it was the put destruction as those downside hedges melted and helped create the mechanical ‘turn and rally’ off the lows,” McElligott wrote, walking market participants through the progression. “Then in recent days, due to the massive under-capture of the rally, the focus has been about getting nets back up to participate in the equities screamer via taking down your shorts.” Now, he continued, “many are coming for upside they don’t have on.”
Of course, it’s still possible the blast of inflation from the Strait closure and all the issues that disruption’s going to cause on a lag will come back to haunt stocks, particularly if there are any “oops” moments during mega-cap tech earnings (which’ll roughly coincide with the realization of sundry physical “friction” in the energy space).
But as Charlie wrote Wednesday, “in the meantime,” funds and traders “are back to chasing performance they haven’t captured.”
There is one difference between this week and last, and that is the U.S. blockade of the Strait of Hormuz. A week ago, taking the “w” meant essentially leaving the Straight in Iranian hands, to which Trump’s response was that European and Asian nations who counted on the Gulf for essential commodities should figure out a way to police the Straight themselves (meaning: we broke it you fix it!) With the U.S. now seemingly in firm control of the Straight — a transition that has been much smoother than we were led to believe was possible (meaning: did Iran even have any mines there in the first place?) — there appears to be an orderly exit, provided some sort of peace agreement is eventually reached, and the U.S. is not required to police the Straight on its own in perpetuity.
“meaning: we broke it you fix it!”
Mr. T, you nailed it. None of those countries signed on to the “excursion” or even consulted about it or knew about it in advance. Now they are being attacked for not lining up to support it.
It brings back memories of “Freedom Fries” and “Liberty Toast”. An amusing sidebar on that happy era came when I was teasing a French classmate/friend about it. In a typical French fashion, he simply asked “Uh, so what do you call French Ticklers now?”
Stepping back, Mr. McElligot’s and your commentaries support my long-held belief that earning do not matter in the short or even medium term. Seriously, how many of the managers pushing around the largest pools of money give a crap about earnings when they buy or sell broad market or, especially, sector-specific ETFS?
The only thing that does support the quaint old nation that earnings are paramount is the impact of earnings on the amounts of money available to support share buybacks. Which is more relevant now that interest rates may deter borrowing to fund more buybacks. As our Dear Leader has reminded us, share buybacks are the largest source of buying by multiples of the other buyers. Outside of the vol-driven model flows which are not at all as permanent as buybacks. Sometimes those guys also sell!
derek- I am learning this lesson in spades. My most recent “biggest problem as an investor” is that I still look at fundamentals to decide when something is overvalued. I’ve trimmed several long held positions in the past 24 months – and then watched them continue marching upwards with good, but not unexpected, earnings growth and an absolutely crazy (and unexpected – at least by me) expansion of PEs.
So frustrating.
Yep. Damn frustrating. We mere mortals really like guideposts to help explain the unexplainable. It seems to me that we should be heeding new ones. At least for a while longer ….
May I humbly suggest that we refer to these mechanical bounces as “boot and rallies”?
“Mission accomplished!”
The market barely goes down, even in the face of staggering political incompetence and obvious pump the next big thing when the last ten don’t work out dynamics. Seems like there is still too much money in the system, chasing too few assets, which also explains the inflation dynamics whenever the markets aren’t soaking up the excess, or billionaires hoarding it.
if the market barely goes down that indicates the smart money is actually betting on Trump to get a big W and agrees with his plan. What does that make all the critics then? Dumb money.