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T1 Alpha Sit-Rep: Thursday, December 22nd
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After the recent selloff, markets thoughtfully paused and considered the incoming data resulting in a modest rise in the averages. Cool story, bro. Add it to the list of things that didn't happen as markets simply careened back in the opposite direction thanks to the existence of a local gamma squeeze pocket. Note the commentary yesterday in the letter:
"Notice the nearby concentration of call gamma which has the potential to pull us higher today despite the overall unfavorable conditions."
When 0dte options stack up on either side of spot, all it takes is a push OVER the resistance and dealers are suddenly chasing. Unlike a dog with a car, they know exactly what to do with it when caught:
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Imagine if FTX and Alameda had actually been competent...
On the economic news front, jobless claims are likely to provide additional fuel to the recession skeptics. Nothing has changed in the poor quality of the data we are receiving, although we'll try to keep you abreast of further developments here. If there is a jump in jobless claims, we'll likely see rates rally (lower yields) and equity markets lower as the correlation between equities and rates appears to have bottomed in November. The "normalization" of this relationship is key to ending the Powell-induced phase of this bear market.
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We remain in negative gamma, this time with the gamma pocket sitting on the other side of the fence. There remain some risks to the topside, but it feels like yesterday was a pause at a refreshing, clear, cold mountain stream for the bears.
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While we're a bit skeptical of the localized vol expectations today with single-day equity vol implied at only 13%, the market sees very little to be concerned about. The upward slope to the vol surface (contango) invites vol sellers to enter and "ride the curve" (sell high, buyback low). All else equal, this is a market positive unless external events (e.g., news) drive a scramble for hedging.
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SPX has made its way back toward the middle of our PV bands as the overall trend continues to push moderately lower. After dropping over 6% in the last week, some consolidation was expected. Now the upper band sits less than 2% away. That doesn't leave a lot of room for yesterday's move to continue, especially as the 3900 strike sits in the way.
While Nike's earnings may have been met with some enthusiasm, we remain cautious heading into next year.
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Tech stocks also pushed higher yesterday, returning toward the middle of our PV bands. Although we expected some consolidation after recent moves, the Nasdaq is still at a high risk of revisiting that 52-week low set in October.
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Like other indices, the Russell 2000 climbed 1.65% yesterday, bringing it back into the center of the bands. The growing volatility of small-cap stocks, however, is indicative of an economic recession becoming more evident. Perhaps the Q4 earnings season coming up will give us our first glimpse of what's to come.
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The S&P 500 index saw a strong gain on Wednesday, with 92% of stocks closing higher. While Nike stole most of the headlines, Apple was actually the largest contributor to the index's gain, accounting for about 12% of the spot return. In addition, Microsoft, Amazon, and Nvidia contributed an additional 8%.
Although the market was largely one-sided, low index correlations helped to reduce some of the volatility as returns offset each other. Among the top ten largest companies in the index, Tesla was the weakest performer, though it remained unchanged from Tuesday's close. It has long been our suspicion that Elon Musk's Twitter adventures were largely about creating the cover to sell TSLA stock in size; nothing we've seen recently suggests otherwise.
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Yesterday's gain saw nearly 14% of the index rise above the 20-day moving average. However, it's worth noting that the magnitude of this move may not be as significant as the overall level of the model. Only 24% of the index's components are above their short-term trends as overall market breadth remains relatively weak.
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According to our research, longer-term breadth models tend to be more reliable indicators of market health because they filter out some of the noise. Specifically, the 200-day breadth measure has been shown to closely track the index drawdowns. Currently, about half of the index is trading above its 200-day moving average, with the S&P 500 hovering just above the threshold for a technical bear market. Despite the move in our shorter-term model, a breakdown in 200-day breadth will likely lead to a revisit of the October low.
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Vol Control Implied Rebalancing:
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As expected, the 1-month volatility saw a moderate increase while the 3-month saw a slight decline. This is mainly due to the data leaving the sample rather than the data entering it, as the two look-back periods were dropping different-sized returns. We expect this type of dynamic to continue through the end of the year, which may lead to moderate buying activity from the volatility control space. Our model uses the higher of the 1-month or 3-month trailing volatility window, with the latter being the current measurement. This means that we expect smaller rebalancing requirements, as the 3-month volatility is less reactive to changes in the market.
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Today, we're not expecting any significant flows from vol control funds unless we breach the +/- 4% level. Given the lack of known event risk for the rest of the week, a move of that size seems highly unlikely. Overall exposure remains low in the 11%ile, about all Vol control funds have been willing to handle since Q2.
It's important to remember that these models are designed so that when realized volatility eventually normalizes, a large influx of cash into the equity market should help drive the next bull market. Unfortunately, significant risks still lay ahead, so we do not expect to see that anytime soon. One of those risks is permanently higher equity volatility due to the growing share of passive and systematic strategies.
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For the last few months, we have reminded readers that the market's focus is switching from inflation risks to concentrating on pricing in the recession.
During a recession, real yields often rise as the rate of inflation falls faster than nominal yields. The effective real yields for risky assets (e.g., dividend yields, earnings yields, etc.) typically increase as investors become more risk-averse and demand a higher return for taking on additional risk. As a result, the nominal yield on risk-free investments like bonds may decline as investors become more selective about where they place their money even as valuations fall.
The bear market of 2022 can be characterized as a bond market rebalancing that caused a spillover decline in the equity market. As the situation progresses, a more typical bear market in equities may emerge as the rebalancing dynamics stabilize. Note that the relationship between gold and real yields suggests either real rates are way too high (remember the chart axis for real yields is inverted) or gold is very overvalued. Alternatively, the Fed is going to get busy cutting rates soon. Don't hold your breath for the latter as Jerome Powell seems to have made this about ego more than economics.
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We always welcome your feedback info@tier1alpha.com. Please follow us on twitter for updates @t1alpha. www.tier1alpha.com
-T1A Research Team
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