September 18th, 2023 | "Pattern of the Day"

Well, we were wrong about Friday: "The ready supply of 0dte strikes and the positioning almost directly in the center of the peak liquidity zone suggests little drama for the day."

Instead, the Nasdaq fell nearly 2%. The R2000 fell much less, down 1.05%, while microcaps fell even less, down 1.01%. The most reasonable interpretation is that the economically more cyclical small caps were buoyed by better-than-expected economic data:

However, the data releases do not really fit the pattern of the day. Instead, while markets were modestly weak following data releases, the Nasdaq 100 plummeted shortly after the market open.

This selloff occurred before option markets opened, suggesting an imbalance in positioning for the largest individual stocks was the culprit. As noted below, the sell-off was heavily influenced by the four horsemen of AI, MSFT, AMZN, NVDA and META. Sometimes it's not all about the indices.

The focus in vol markets remains on the Fed meeting although it would be hard to suggest the past two months has created meaningful clarity. Employment has been weaker, prices, driven by energy, a bit higher. The Fed has found itself with little new information. Consensus is firmly on a pause for September (0.8% chance of hike), a bit less comfortable about November (31%) and overall viewing the odds of another hike by end of year as less than 50%. However, all the action has been the market pricing out interest rate cuts in 2024 as consensus builds around a soft landing narrative.

For the week, while the calendar is obviously dominated by the Fed meeting, we'll receive more housing and PMI data as well. Given poor price action in homebuilders, higher interest rates, and deteriorating sentiment in the NAHB survey, we're on board with consensus that results will be modestly worse across housing data (new and existing). Cancellations in August for previously signed deals have apparently surged which may lead to some revisions.

Gamma Exposure:

Friday's sell-off was likely facilitated, although not caused, by the steepness of the gamma surface. Once dealers saw markets moving lower, they likely proactively chased. Our hunch is that a looming weekend and vol targeting strategies contributed to the speed and unexpected depth of the move.

Note that the availability of strikes has deteriorated. This is likely to lead the market to become "twitchier" in vol space than it has been recently. Combined with seasonal expectations for higher volatility and we'd suggest a plausible pause in les bonne temps.

Probable Volatility Bands:

Last week, we pointed you toward European equities for hints about the direction of US markets, specifically suggesting a potential drop for the Dax from around the 16,000 mark. While there hasn't been a dramatic decline, the consistent lower highs in European stocks are noteworthy. We'll delve deeper into this in today's webcast – keep an eye on your inbox.

Today's SPX PV bands indicate a slight lower high and lower low, with the upper band at 4523 and the lower one at 4426. Things are looking relatively stagnant as we approach the FOMC on Wednesday. The 4450 strike appears to be significant today, mirroring its importance in June and July. There's much wood to chop on the SPX; it might not be the most straightforward index to navigate today unless we hit one of the band extremes.

The 15150 level for NDX is to SPX the 4450 level. At support, but making daily lower highs makes things tricky here. A retest of the 15400 strike potentially takes this below the 15150 level to visit the bottom band at 15090. That opens the door to more downside.

Bearish but floating in the middle of its range for the bank-heavy Russell. Top of the bands at 1890 with the lower end at 1809. The R2000 range is nearly as wide as the SPX range, which tells you a lot about the relative volatility of the Russell, absent the mega-cap distortion we see in its larger siblings.

S&P 500 Market Breadth:

Intraday breadth flipped hard last Friday, leaving 81% of the index in the red. Even so, the average decline was only moderate at -1.18%, and the total average return in the index was only -0.84%.

So why did SPX fall well over -1%? Look no further than Microsoft, Amazon, Nvidia, and Meta, which collectively hold a 15% weight in the S&P 500. Since market breadth was already weak, and these four companies were down between -2 and -4%, they were easily able to distort the spot price by magnifying the decline.

Last week, we warned that the jump in our 20-day breadth model was likely a false signal, and the price action on Friday confirmed our suspicions. The key thing that caught our attention was a lack of follow-through in our longer-dated breadth models, which typically hold a much closer relationship to index drawdowns. While we could see this jump back up again this week, our confidence is low that it's signaling a meaningful change of trend.

Currently, only 30% of the index is trading above their respective 50-day moving averages, which is exceptionally weak considering SPX is only ~3% away from its 52-week high. Again, it's hard to have a lot of confidence in the market when breadth is this low.

Quant Fund Implied Rebalancing:

Realized volatility increased last Friday, prompting vol control funds to mechanically sell equities. Remember, vol control funds use realized volatility as a toggle for their risk exposure.

When realized volatility increases, these funds have to rebalance out of equities in order to maintain the target level of volatility in their strategy, which is usually set between 10-15%. While some funds may have some bond exposure, vol control funds will typically rebalance between equities and a cash position via a money market since their goal is ultimately capital preservation during a volatility event.

In the case of last Friday, these funds had to sell an estimated $11 billion in equities, which added significant selling pressure on SPX.

Since markets have grown more inelastic with the growth of passive funds and indexation, recent research suggests that flows like this tend to have a multiplier effect added to them, which means that $11 billion likely had a much greater impact on overall market valuations. This highlights the inherent risks of institutional funds on the broader market, as large-scale liquidations can exacerbate volatility.

Today, we're expecting to see more selling take place, although how much will depend on what the market does. That said, another 1% move (either up or down), would lead to between $7.5 and $10 billion in additional selling flows hitting the tape, which would create an unfavorable environment for equities.

Bonus Chart:

Today's bonus chart offers a glimpse into next week's data, while also highlighting a cautionary message about mean reversion from significant peaks. Historically, durable goods have acted as an indicator for consumer health, and akin to the Fed's regional manufacturing data, the new order components provide a lens into consumer spending for the upcoming quarter. What raises eyebrows is the high point durable goods demand has reached; a mere average reversion could potentially signal a 25% drop from current levels.

Durable goods orders represent new requests made to manufacturers for the delivery of long-lasting goods, typically with a lifespan of three years or more. This includes most appliances, with the exception of Samsung refrigerators, which some jest, might not last the full three years.

Data from the previous month was somewhat skewed due to a broader dip in demand for civilian aircraft and transportation. In July 2023, US orders for such goods saw a 5.2% decline, the most pronounced since COVID-19's emergence in April 2020. Following a 4.4% uptick in June, this drop outdid market forecasts of a 4.0% shrinkage. Transport equipment demand was particularly hard-hit, with a 14.3% decline. Civilian aircraft orders took a 43.6% hit, and defense aircraft orders decreased by 10.9%. Some sectors, like computers and electronic products, witnessed drops, whereas machinery, electrical equipment, and appliances grew. Worth noting is the 0.1% July increase in non-defense capital goods orders (excluding aircraft), commonly used as a measure for business investment intentions.

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