The 2750 key support level of the S&P 500 is being seriously questioned, as the market oscillates violently around that level. It briefly breached that low on October 12, managed to regain it and rally 2.5%, only to fall back towards it on Friday. Large-cap quality stocks rallied between 5%-10% from their lows, only to retest them back on Friday, increasing concerns that the rally of last week was a "dead cat bounce." What is going on outside Fed commentary and U.S. dollar moves, and what has really been driving the market in October so far?
There is no doubt that the market is vacillating between macro headwinds following economic slowdown and robust company earnings; not sure which way to go. The volatility does not help. In addition, given the moves in bond yields and the yield differential between equities and bonds, risk parity funds have to balance their portfolios by switching out of one into the other to balance their liabilities. In this case, buying bonds and selling equities -- given the blow out in yields recently. We could see the end-of-day selling pressure as U.S. market sells off into the close over the last half an hour. According to a JPM report released on Friday, "systemic outflows were balanced by inflows from fundamental buyers, fixed weight rebalances."
But another, much more powerful driver has been influencing the markets as well; S&P 500 index option expiration. If one were to study the total open interest held in option strikes around 2850, 2800, down to 2750, the size was quite significant. These were all expiring on Friday October 19. In layman terms, most institutions are long puts to hedge their equity exposure (downside protection). Generally, market makers (investment banks) are short these puts as they sell them to the institutions. Being short puts mean they are short the market as it rallies through the strike, and long the market as it breaks below.
It is a very precarious position to manage going into expiration, when the trader does not know whether they will be short or long the market as the delta of the options violently swing from 100 to 0. The wonders of negative gamma hedging! This risk management causes violent swings in the market. That is what we saw all of last week, as no one could tell whether market was heading towards 2900 or down to 2700.
The options have now expired and the market is "free" to behave in a more natural way. If one were to look at the dollar, yuan and bond yields, there was not much change last week. The volatility and uncertainty mostly came from equity markets. Sure, Fed minutes did not help, but they were nothing other than a very two-sided commentary on possible upside and downside, not as hawkish as the market perceived it to be.
The reversion of the options hedging program should have a positive impact on the U.S. market this week, as futures were sold down into Friday (possibly hedging as traders anticipated being long while the market flirted with 2750 level). Now fundamental investors could also return, given China's efforts and commentary to stabilize the market. The People's Bank of China made net injections of 120 billion yuan in open market operations on Monday, which is supportive.
As we go through third-quarter earnings season, the "blackout" period for most companies ends, meaning we can see buyback activity pick up going forward. This has certainly been a positive factor helping markets in 2018. Most companies cannot buy back their stock 30 days prior to earnings; will they start being active now given their stocks are so much cheaper?
Fundamentals aside, there are a lot of "technical" flows at play here. The market is all about liquidity. It is important to make a distinction on what is really driving the market, and separate the technical from the fundamental. One should never discount triple witching and option-related index future flows, which tends to drag all the stocks that are a part of it (in this case, tech stocks as S&P 500 comprises of a lot of them), namely Amazon (AMZN) , Google (GOOGL) , Apple (AAPL) - FAANG suspects. Go figure. The derivative set up in markets tends to be underestimated, but one should never forgot how large the derivative market is.
It will be interesting to see how end-of-day flows this week compares to last week. If earnings appear to be as positive as they have been, one can only assume the market grinds higher slowly on fundamental flow support.
