September 22nd, 2023 | "Buyside Was Underhedged"

Well, we've warned all week about the dominance of interest rate markets, and yesterday was about as clear as it gets – no one wants to stand in front of bond issuance. This is not a US phenomenon. Developed markets globally have moved in lockstep. Everywhere around the globe, domestic bonds are following central bank policy direction – higher in the developed world, lower in China (where the BoC has been cutting), and MUCH higher in emerging markets like Turkey.

While US equities were down 2% yesterday, the US long bond (TLT) was down over 2.5%. In the list of "worst bond selloffs" since the TLT ETF was introduced, yesterday came in at #27. About half of these bond selloffs have seen equities decline as well:

The move has left markets on edge, with our previously calm short-dated vol surface now looking like a snake writhing in agony. No particular date stands out as a catalyst, suggesting yesterday's VIX spike was consistent with our repeated fears that the buyside was underhedged going into the fall:

Yesterday was an interesting outlier as intraday vol came in below expectations as there was no retrace during the day – pretty much a straight shot to the downside suggesting dealers chased, but never fully caught their negative gamma positioning as additional downside hedges were bought during the day.

Today's economic calendar will be looking for some signs of a trough in global manufacturing PMIs against likely deterioration in services. Next week, we'll start adding more housing data back into the mix and would highlight that Truflation is now seeing negative YoY rental price levels. This suggests a sharp deterioration (lower inflation) is ahead for US shelter prices.

Gamma Exposure:

Our fear that markets could break lower and test the gamma trough turned out to be correct. While we were surprised that the market blew through our lower PV bands, we had emphasized the growing role that rates weakness had played in market behavior. It's not ALWAYS about the options.

While we believe the very short-term setup favors a rebound, we've again begun to press against the lower limits on available strikes in 0dte. Remember these options are created two weeks before and with the S&P dropping sharply below recent consolidation, the risks of a materially higher move in implied volatility cannot be ignored.

Probable Volatility Bands:

It was a tough day for our PV bands, with SPX closing nearly 1% outside of our lower range. We initially flagged the 4375 strike as a key level to watch, but once the market opened up at that level while dealer flows were kicking in, we saw that free fall toward the 4350 strike and beyond. Breakouts like this are rare, but they do happen.

In fact, SPX has closed outside of our ranges around 10% of the time over the past decade, which means they have a 90% hit rate with only a 4.5% average spread. For comparison, Bollinger bands have an average spread of nearly double that!

For today, we'll be opening up at the bottom of our ranges, which means this setup largely favors the bulls. Note our key strikes in play for support and resistance levels today, but it's only fair to point out the 4300 strike sitting outside of our bands, which is only about 70 basis points below.

In yesterday’s note, we wrote, “Zooming out a bit further than today, NDX is now confirming a big daily lower high; this implies a lower low beyond 14696,” this statement didn’t age well because it didn’t age at all, we got there in one trading session.

The range has expanded considerably with the added volatility. The bottom of today’s range is 14646. The 14800 and 15000 strikes would be the most aggressive levels to hold as resistance. The top of the range is 15301, which would be a surprise today. All indications are that NDX will go considerably lower in the coming days. Patience and sound risk management are fundamental as this Vol picks up; it goes without saying.

The biggest challenge with Russell in the past couple of months is getting anything toward the top of the range to gross up the short side; this is the value of a diversified short book. It’s a good problem to have; it means we are in an accelerating trending bear market.

Range top and important strike today at 1850, lower PV band situated at 1765.

S&P 500 Market Breadth:

SPX breadth was extremely bearish yesterday, with over 92% of the index in the red. This is one of the most skewed days we've seen this year, leaving few places to hide within the S&P 500. To make matters worse, the average decline was -1.92%, which means the pain was not only widespread but also quite severe. Thankfully, Apple and Microsoft were only modestly lower, which helped stem off further losses at the index level.

50-day breadth collapsed yesterday, leaving just 18% of the S&P 500 trading above their medium-term trends. This puts it into the low 6%ile over the past decade, a level we've only seen one other time this year. 200-day breadth also shifted lower, with just 40% of the index still trading above their respective longer-term trend. If this deterioration continues, it's hard to imagine a scenario where SPX can move materially higher from here.

We've also seen a huge spike in oversold conditions over the past few days, as 16% of S&P 500 components now have an RSI reading under 30. While 16% may seem modest, this actually ranks in the 95%ile over the past decade, and highlights how quickly things deteriorated since the start of the week.

Quant Fund Implied Rebalancing:

Yesterday, we wrote that it was going to take a big move for Vol control funds to start selling, and a big move is exactly what we got. The 1-month realized vol shot up another 5.3% to 12.65, which meant vol control funds had to start mechanically selling equities in order to maintain their volatility targets.

Not surprisingly, these selling flows did not start hitting the tape until later in the day, which is why we suspect SPX fell so hard toward the close. Overall, we saw an estimated $10.6 billion of equities sold off, which brings this week's total to over $16 billion in selling flows.

CTAs were also actively selling yesterday, pushing another $8 billion in bearish flow into the market. In total, CTAs have unloaded around $25 billion in equity exposure over the last two weeks. When CTAs start selling, things tend to deteriorate quickly. Unless SPX starts to catch a bid soon, we expect these funds will continue to lower their equity exposure, which will add an increasing amount of pressure onto the market.

Overall, our systematic positioning index is still in the 81%ile, as realized vol levels are still relatively low. This means there is a lot of downside risk if volatility continues to perk up, which we consider to be the greatest threat to the equity markets.

Remember, in an inelastic market, these flows matter!

Today, bulls may get some help as vol control funds will likely add back some risk exposure, as another volatile day is set to drop from its sample window. We could see between $6 billion-$14 billion in bullish flows hitting the market, as long as SPX can stay within a +/- 1% window.

Of course, we know how this turned out yesterday, so keep an eye on the tails if SPX starts to breach that window. If we do, there is another $14 billion-$17 billion of selling that would take place at around a ~2% move.

Remember, while we can't predict the markets, we can broadly predict how these funds are going to react under different scenarios. There is no crystal ball. It's just data and math!

Bonus Chart:

The Philly Fed represents around 11% of the US population. This week’s report went back to the 16-month contractionary trend.

The diffusion index for current general activity slipped from 12.0 in August to -13.5 in September, marking its 14th negative in the past 16 months. Firms reporting decreases rose to 29%, surpassing the 16% reporting increases. Indicators for new orders and shipments also declined, with the new orders index dropping from +16.0 to -10.2 and the shipments index decreasing to -3.2. Employment continued to decline, with the index at -5.7, as 19% of firms reported a drop, 14% an increase, and 67% saw no change. The average workweek index slightly decreased from 6.3 to 4.7.

Overall, this was a very disappointing report for the soft-landing/re-acceleration thesis.

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