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Recent notes have been somewhat negative, bearish even. We think that's with good reason, but that doesn't mean markets are heading straight to the depths...
If there's one market principle we could hammer into people's brains, it's that the path matters more than the destination. Any trader, investor, market-watcher needs to nail that to their screen. If they're permabears, preferably using a big nail, right in the centre.
So, why are we leaning bearish?
Overextension leads to correction
Various flow metrics point to traders chasing the rally...
CTA's are estimated to be NEAR MAX LONG by Goldman's Scott Rubner in a note titled "Hike in May" and Go-Away (from Equities) 👇
Flow dynamics are starting to change, we expect the market to move more freely next week and non-fundamental technical demand starts to run out of gas (this is in inning 9 for flow-of-funds).
The gist is essentially that these systematic buyers are all out of bullets, while fundamental buyers are looking at the backdrop and saying 👇
"Buy here? You're having a laugh mate! Call me back when SPX is much lower"
Meanwhile, retail investors have largely moved into money market funds for some easy yield while the crosswinds resolve. Summarising, Rubner says...
The extremely net positive April equity flow-of-fund demand dynamics have started to wane, this is not a negative dynamic, but no longer a market positive tailwind.
Technical supply doesn’t pick up until a major equity move lower.
Rubner's made some good calls of late, but nobody's an all-seeing oracle in this game.
So where's the technical supply? 4040 is the earliest buy zone if we're feeling REALLY bullish, but could SPX need more of a discount (sub-4000?) to tempt buyers back to the party?
Maybe back to the 200DMA?
Likewise, option expiries from the end of last week are expected to 'release' the market from the clutches of those dastardly option dealers...
Here's a snippet from 530, one of our big-brained Macrodesiacs, on why that matters 👇
And here's JP Morgan visualising the 'how' of these option flows... 👇
Along with an explanation... 👇
Gamma positioning appears to have turned long as the market rallied, and dealers’ hedging activity is likely compressing market volatility, helping to explain why close-to-close realized volatility on the S&P 500 is down to single digits.
Figure 2 shows the S&P 500 gamma imbalance profile as of yesterday’s close, and after April expiry when ~$1.2Tr of S&P 500 option notional rolls off.
Today’s expiry should see the recent long gamma overhang ease somewhat, with the imbalance decreasing by ~25-30%. As the chart indicates, after today’s expiry dealers would likely be significantly short gamma (put imbalance) below ~4050, flat gamma near 4100-4125, and significantly long gamma (call imbalance) above ~4150.
Gamma, as with many options terms, is somewhat confusing. In these examples, the assumption is that option dealers need to maintain a hedged book. They don't want directional exposure.
Explainer via SpotGamma
Options market makers hold large numbers of options positions. When they initially trade, they buy or sell a set number of shares to hedge themselves – this is referred to as a “delta hedge”.
If the market makers are net short calls that means they likely hold a large quantity of shares to hedge themselves. Should the underlying stock go higher, the market makers must purchase more shares to maintain this hedge. This is called a gamma hedge.
The act of having to purchase large amounts of stock to maintain a hedge may push the underlying stock to rise in price. This leads market makers to have to purchase additional shares, which could lead to a self reinforcing cycle of buying. This is what is referred to as an options gamma squeeze.
The same dynamic is true for downside exposure. Dealers need to sell the underlying which can reinforce a selling cycle.
Gamma aside, it looks as if the majority of the potential upside has played out for now. Tactically speaking, getting bullish here just doesn't seem like an asymmetric opportunity.
We touched on the complacency we're seeing last week...
And while there's lots of chatter about the debt ceiling being problematic, we're not quite there yet.
In any case, the biggest risk for broader markets isn't the debt ceiling itself, it's the things happening around the debt ceiling.
Two main factors:
- Negotiations around spending cuts (or not) and the impact on the growth outlook
- The liquidity hoover effect when the US Treasury's bank account needs to be refilled.
Before all of that, we've got the Fed likely to hike once more and pause on the 3rd of May. Around the time of that Fed meeting, we'll also get the latest instalment of the lending survey (or SLOOS). More on that here 👇
We'd expect lending conditions to have tightened again, but it's the magnitude that matters. In more recent commentary, some lenders have spoken of slightly tighter conditions, but nothing major so far. A glacial-speed credit crunch...
Earnings have also held up reasonably well so far. Pockets of weakness rather than broad pressures. This week we get a deluge of earnings reports, around 40% of the index (including most the big guys) 👇
Earnings beats could be a catalyst for one final push higher in SPX, but I don't think it would be sustainable with the positioning dynamics mentioned before.
It's practically May. We've likely got a couple of tougher months ahead for risk markets, but once those obstacles are cleared, the fiscal side of the ledger might keep the economic engine whirring (depending on concessions in the debt ceiling negotiations)...
This is well worth a listen on that front 👇
So, while it seems like a good time to be tactically bearish (or at least not bullish), beware the negativity bias. The crosswinds are still blowing hard...