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Is a Stock Market Melt-Up on the Cards? | The Big Conversation | Refinitiv - YouTube
Channel: Real Vision Finance
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The S&P500 managed eight consecutive new all-time
highs until Monday, November the 8th, prompting
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many to think that a year-end melt-up is already
underway.
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The last couple of months of every year, however,
are always a tricky period because seasonal
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rallies can be punctuated by sharp pullbacks.
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So what should investors be looking for this
time and what are the ways that people are
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playing it?
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That's the Big Conversation.
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Many risk assets have been on a tear.
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The S&P500 has had a virtually uninterrupted
rally since the five percent pullback into
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the end of the third quarter.
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In fact, October was also the first month
since before May in which we didn't get the
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usual expiry led pullback, even for a few
trading days.
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Retail activity, especially in the options
market, will play a key role in the performance
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of the US equity market into the year end.
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The major option expiries will also give us
a few staging posts on the way around which
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we should expect market gyrations to pick
up in both directions.
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The reason why retail is key is that they
have become a major player over the last couple
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of years, especially since the onset of the
pandemic.
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Now, prior to that, the bid in the equity
market was primarily the result of dispassionate
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buying from pension funds and the corporate
buyback bid.
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These were stable and constant, and their
weightings into equities was often defined
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by technical measures such as volatility.
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As long as volatility remains stable, these
flows will remain positive.
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And that's one of the key reasons why central
banks are keen to keep a lid on volatility
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across all asset classes.
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Now last year that changed when retail investors
returned to the market with a vengeance.
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Although the retail interest started to pick
up prior to the pandemic, with long positions
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in Tesla being expressed through out-of-the-money
call options from late 2019 right into the
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beginning of 2020.
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But once the pandemic hit and the market started
to rally again, options volumes were accelerated
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by large volumes of small-scale retail interest.
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Recent volumes have almost returned to the
peak of the GameStop craze from the early
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part of 2021, and we can see with this increase
in volumes, there's been a huge surge in call
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buying, nearly doubling from the average levels
of the previous years.
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The favourite types of trades for the retail
community have been short dated call options
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often bought two to three weeks before they're
about to expire, and usually quite a long
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way out of the money, so that more positions
can be bought for the same outlay of premium.
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And this has been a key factor all year.
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Favourite stocks have been tech giants like
Apple and Amazon and Tesla, along with the
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various meme stocks that have been floating
in and out of vogue all year.
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The surge in retail activity becomes even
clearer when we look at household margin debt
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levels held at brokerages.
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From 2015 to 2020 this hardly went anywhere,
but it skyrocketed over the last year, playing
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catch up with a market that had previously
left retail investors behind.
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There's also been a surge in put activity
too, though the increase in open interest
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has fallen well short of the surge in call
buying activity.
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Now, given this interest in calls vs. puts,
it may be a surprise that it's the volatility
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on puts that's risen the most over the last
two years.
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As we've seen on numerous occasions before,
Skew, which is the difference between the
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volatility and a low strike vs. the volatility
in the equivalent high strike - for instance,
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95 percent vs. 105 percent well, that it touched
an all time high.
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And although this measure has receded, it
still remains elevated on a long-term view.
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The primary driver of this has been aggressive
buying of the out of the money puts pushing
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up volatility of those lowest strikes, whilst
the retail buying of calls has often been
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met by selling from institutional money managers,
taking advantage of those high volatility
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levels to overwrite positions and generate
income.
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Although as we saw earlier this year being
short those strikes, that can be fatal.
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But this framework sets up a potentially powerful
but also very fragile outlook for the remainder
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of the year.
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Call buying is still the favoured mode of
operation by the retail crowd, but there are
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also signs that retail are trying to get more
bang for their buck by selling puts in order
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to generate income, to buy more calls and
build up additional leverage.
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Another feature, which reflects both the potential
power and the fragility of the market, is
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that both volatility and the S&P have recently
been rising together, and that's actually
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quite rare.
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Normally, when the S&P grinds higher, the
VIX tends to drift lower.
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As you can see here, it's generally a mirror
image.
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The current move higher in the VIX doesn't
look that impressive, but given the sustained
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rally in the S&P500, many would have expected
the VIX to have fallen through the lows of
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the year.
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Periods when volatility and the market have
risen together include the dotcom era and
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more recently, the weeks before the 'Volmaggedon'
event of 2018, when many volatility products
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imploded and briefly caused the market to
wobble.
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You can see that 2018 was much more derivatives
and volatility event than a pure market event.
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When we look at the Volatility of Volatility
Index, which made a new high at the time,
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well above the levels experienced during the
great financial crash of 2008 and only bettered
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by the pandemic shock and passive unwind of
March 2020.
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The point here is that rising volatility and
the rising market often come with higher risks
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of sharp technical drawdowns.
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Going into the end of 2021, when we could
easily get some gamma squeezes in the market.
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And these have been frequent events throughout
the last 18 months.
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It's where investors buy out of the money,
calls in very, very large size.
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But because they're so far out of the money,
the actual hedge that's needed by the market
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makers isn't actually that much.
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It might be something like five shares versus
every 100 shares in the options contract.
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Now, if the market rallies towards this concentration
of open options positions, especially if the
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stock price is approaching them as the expiry
of the options draws near, then market maker
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needs to buy more and more shares at an increasingly
faster pace in order to remain market neutral.
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And this activity can accelerate the price
of a share into and through those strikes.
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If there are options on enough individual
shares that represent a big enough part of
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the market, then this can also have a significant
impact on the index as well.
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Today, the likes of Google, Microsoft, Amazon,
Apple and Tesla well they account for a larger
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part of major indices than ever before.
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Therefore, options activity in these shares
can have an impact on the broader market.
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But one of the problems with analysing these
positions is that options don't define the
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direction of the market, but they can accentuate
it and in both directions.
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As the expiry and the strike approaches, the
market can start to oscillate aggressively
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around those key strikes.
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Between now and the end of the year, there
are two major monthly expiries.
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These take place on the third Friday of each
month.
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We've got November the 19th and December the
17th, though the main one of these is the
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quarterly expiry in December.
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This, along with March, June and September,
are usually the highest volume options expiries
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every year, and tend to be the focus for institutional
investors.
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There are other weekly expiries favoured by
retail investors, but the third Friday still
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reigns supreme, as we saw in that earlier
chart showing how the major U.S. equity indices
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had wobbled into many of these events since
May of this year.
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Now, the December expiry is particularly significant
because after the third Friday of that month,
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market volumes generally tail off into the
rest of the year.
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The main exception to that rule was a sell
off into the end of 2018, after the Fed misstep
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of raising interest rates into an already
falling market.
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That saw the S&P accelerate lower again, showing
the impact that the expiry can have on the
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size of the move.
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Now, we shouldn't expect the market to carve
out a straight line over the coming period,
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even without some of the potential pitfalls
that i'll mention later.
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Seasonality has usually been quite favourable
into any year end, but there is normally a
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wobble toward the end of November.
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The risks that a pullback could turn into
something more dramatic have increased because
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of that influx of retail investors.
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But why is that?
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Well, if this market was still dominated by
corporate buybacks and pension flows, then
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these would largely ignore macroeconomic events
as long as those events didn't cause volatility
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to surge and upset the rules-based models
that most of them follow.
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These types of flows are devoid of emotion,
but the same cannot be said for retail flows.
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Retail investors, as we've seen from many
social media sites, are extremely expressive.
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Valuations don't cause markets to fall for
an extended period, it's a sustained period
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of disaffection from investors that does.
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That may seem obvious, but back in early 2020,
there was little retail participation.
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Therefore, once the markets have been stabilised
by policymakers, the rules-based investing
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continued as it had before, whilst retail
inflows started to accelerate.
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Today we have conditions in which retail investors
could now offset the stable flows of buy backs
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and pensions.
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It's unlikely that they're sufficient to fully
counteract them at the moment, but they are
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now sufficient to meaningfully impact market
volatility and increase the market movements
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in both directions.
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This in turn, will feed into many of the rules-based
investing mandates, which in turn will add
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another layer of potential volatility.
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Thus, volatility begets volatility.
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Therefore, investing in the market via call
options remains a good way to mitigate risk,
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and these long volatility positions will benefit
from a surge in volatility even if the market
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goes in the wrong direction.
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Now, call volatility has already increased,
but it still remains relatively attractive
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versus the volatility of the underlying market,
whereas put volatility is still expensive
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and may cost 5 to 10 points above the actual
volatility of the market.
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Some of these puts may look attractive, and
for those who understand the risks, there
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is some juice there.
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But the increased put selling to fund call
buying also opens the possibility that the
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downswings when they come, could be more aggressive
than we've been used to for most of the recovery
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off the 2020 lows.
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And furthermore, there are some macro issues
that are bubbling beneath the surface.
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China is continuing to attempt to rebalance
the economy.
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So far, this has been a measured move and
one that's been largely ignored by the wider
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market, reflecting the introspective nature
of China's current economic policy.
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But since the Evergrande headlines, however,
China's property sector has remained under
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sustained pressure.
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The June 2030 bond of Country Garden Holdings
has lost 10 cents in the dollar since the
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beginning of November.
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The Sino Ocean Land May 2029 bond has fallen
close to 15 cents in the same period.
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This is a company that's perceived to be backed
by regional governments.
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These issues in the offshore dollar bond market
are repeated across a number of companies,
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and this has all taken place since the last-minute
payment of Evergrande's dollar bond holders,
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which it looked like they were going to default
on only a few weeks ago.
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China's real estate index is significantly
underperforming the broad-based market as
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the issues spread further, and this has been
reflected by another leg lower in the Asia-Pacific
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High Yield Bond ETF, which has fallen well
below the spike lows of the pandemic bust.
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So far, all this appears to be contained.
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Global investors expect that contagion will
not spread beyond China's property sector
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or outside of China and its territories.
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But there have been some very clear reversals
in China's headline commodity sectors, such
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as iron ore and thermal coal.
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Iron ore has dropped by nearly 60 percent
to below the pandemic levels in a sign that
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some of the commodity exporters to China may
soon see lower prices and volumes.
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The Baltic Dry Freight Index, which reflects
global shipping, has posted nearly two weeks
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of straight declines.
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The point is that China might not be an issue
right now, but it can easily become an issue
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in the future, given its pivotal role in true
global growth.
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Back in early February 2020, the pandemic
was well known, but the U.S. equity market
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continued to make new highs into the middle
of that month.
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The base case today is that the U.S. equity
market will continue to rally into the end
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of the year, but investors need to be wary
that the acceleration of retail investors
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buying the upside gamma while selling puts
to finance leverage could combine with the
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proximity of the major expiry December to
accentuate any external risks that could spread
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from China.
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Equity markets continued to rise with rising
volatility into the dot com peak of 2000,
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but there were many extreme durations along
the way.
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Long calls or even selling out of some stock
positions to buy calls and bank some capital,
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are some of the ways that investors are looking
to participate into the hoped-for year-end
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rally whilst managing their risks as this
market continues to power ahead, whilst at
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the same time it becomes increasingly fragile.
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If you have any questions about this episode,
the markets or the economy, please put them
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in the comments section or send them to TBC
at Refinitiv dotcom.
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