September 19th, 2023 | "14 Is NOT 40+ Vol"

Once again, we're tempted to break out the "Memes of Excitement," although for rates traders, it's more like "The Pit of Despair!"

Both rate and equity markets have made clear that tomorrow is the radical (get the math joke?) solution to uncertainty, with single-day vol pumped all the way to 14 from a resting heart-rate of 11. Interestingly, the continued relative bid for vol suggests the possibility that markets view tomorrow as a bit of a litmus test. A hawkish Powell likely proves very dollar-bullish and pulls forward 2024 concerns into 2023; a dovish Powell could undo many of the markets' growing interest rates fears and ignites the proverbial "blow-off" top in risk.

As our readers know, our bias is that a hedged pot never boils, but we have to remind ourselves that 14 is NOT the 40+ vols that we would regularly experience for similar single-day events in 2022. In other words, "likely calm with a chance of hurricanes."

While all eyes will be on tomorrow's Fed meeting, we do get a few important data points today about the housing market. With interest rates pushing higher and new home contract cancellations apparently very elevated in August, we will be closely watching this data as we prepare the hors d'oeuvres for tomorrow's Super Bowl.

Gamma Exposure:

With dealers in negative gamma and a relative paucity of strikes below us, we have some concerns that growing intraday hedging for tomorrow's event could pull us lower through the day. But as always with single-day action, it's very much a coin flip. Regardless, with dealers chasing in either direction for the time being, there should be a reasonable tug-of-war on an intraday basis.

Obviously dominated by single-day option expiry, once again the gammas by strike suggest a localized range of activity. If a jump occurs today, our bias would be lower; but that jump seems unlikely barring exogenous events. One note is September VIX expiries today that could lead to some recycling of risk into October or December, causing a "VIX up"/"Stocks flat" dynamic.

Probable Volatility Bands:

SPX couldn't quite escape the 4450 strike today, as our PV bands have started to turn slightly lower. That said, the strikes in play remain the same. Keep an eye on the 4475 strike to the topside, and the 4425 strike to the downside. Overall, though, the September consolidation range seems intact.

We highlighted 15150 as a decisive support level yesterday, and in the short term, it has held. The question now is, what next? In the past few months, we've turned to European equities and the dollar for intraday correlation cues. Cable seems positioned for a slight bounce, leading to mixed signals from the dollar.

Delving into the range, the top is 15559, and the low is 15026. Significant strike above the price sits at 15350. It's plausible that the 15350/400 range will push the price back down to retest the 15150 support as we approach the FOMC.

While there are challenges in divining the short-term direction for NDX, there are fewer directional challenges for the Russell. It is a bearish trend and we think going lower. The upper band has moved down noticeably from the past two trading days, sitting at 1983 now with the low end of the range at 1803.

S&P 500 Market Breadth:

Breadth was well-balanced yesterday, with just 53% of the index in the red. The average decline was moderately larger than the average gain, but with Apple advancing nearly 2%, the index was able to remain flat for the day. Correlations remained low, which also helped to minimize any volatility, as the broader index was largely just canceling itself out. Overall, it was an uneventful start to the week.

If you thought the 12-month, 24% rally in SPX has been bullish for the entire index, think again. Only 35% of the S&P 500 has managed to outshine the index itself, marking one of the lowest percentages we've witnessed in the past decade. This suggests a scenario where the lion's share of returns over the past 12 months has been consolidated within the hands of just a select few companies, leaving the majority of the index trailing behind. You read it here first.

This doesn't necessarily imply that the lagging companies haven't made progress, but it does underscore the challenges faced by active managers in surpassing their benchmark, given that an overwhelming amount of the index has been underperforming. Essentially, it's been a tough market to be a stock picker for large caps. For small-cap managers, it's been much easier to beat your benchmark – just lean large!

Quant Fund Implied Rebalancing:

Realized volatility was flat, which meant vol control funds were left sitting on the sidelines yesterday. Consider this a lucky break since there was a large amount of potential selling if volatility had volatility picked up, which would have put some downward pressure onto the market. Instead, there was only negligible rebalancing flows, which we suspect were easily absorbed into the tape.

Looking ahead, we suspect we'll see vol control funds buying toward the end of the week, with both Thursday and Friday set to drop some fairly volatile returns. All else being equal, the 1-month vol could fall back into the low 10s, which would trigger vol control funds to add back a substantial amount of risk exposure through purchasing equities. This should create a supportive environment after the Fed this Wednesday, as systematic funds will likely be buying in the background.

Of course, any surprises from Powell could act as the dominant factor, so we'll have to reassess when the time comes.

Today, expect more to the same. Some moderate buying flows between a +/- 0.5% return, with some strong selling picking up around a ~1% move. Given dealers are still in negative gamma, we see a higher probability of some selling flows being triggered, although how much (if any) will depend on how the markets perform.

Bonus Chart:

The National Association of Active Investment Exposure index reflects the two-week moving average of exposure to US equity markets as reported by its member institutions. The NAAIM exposure currently reads at 57.98.

The NAAIM serves as a dependable contrarian gauge. No offense, active managers; many of us are in the same boat. Check your emails from August 18th and 28th for further insights.

Currently, the index finds itself at a "just right" exposure level – not too high or too low. We tend to find it more compelling when it's at the extremes, so there is little information currently. In our recent webcast, we discussed the challenges active managers/Pod shops faced throughout 2023. David pointed out the contradictory fundamental signals active traders receive week after week.

Active managers are aware that typically, there's a 14-month delay from when the 3-month and 10-year yields invert – pointing to a December 2023 recession. They're also clued in about student loan repayments resuming in October, the looming CRE debt crisis, challenges with auto subprime loans, consumer credit card spending, tightening lending criteria, the robust dollar, the dip in GDI, and the all-time low in housing affordability. With such a stark disparity between data and market reactions, it's immensely challenging for them to take substantial positions at opportune moments.

This is where flow comes into play. As long as there's employment, positive passive flow remains. When the employment falters, the flows can reverse. An oversimplification, perhaps, but essentially accurate. The NFIB disclosed in August that 40% of small enterprises had vacant positions they couldn't fill, suggesting continued support for flows even as those incremental flows weaken in magnitude due to slowing employment gains.

Disclaimer:

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