The past seven days have been intensely brutal for both bulls and bears as the market violently moves below 3000 to above 3100, after u-turning from close to its rally all the way to 3250 from March lows. This will carry on this week till we reach Friday expiration of the S&P 500 index, futures, and options, commonly known as Triple Witching. These occur every quarter and are very significant from not only a flow perspective but due to the sheer size of interest that is invested in June that is about to expire. A lot of decisions are to be made about rolling down protection, or hedging as the day comes nearer. Take all of that flow and combine it with a temperamental market, knee jerk trading on any vaccine headlines, to a bearish macro-economic backdrop on an expensive, fully priced market, and that provides the reason for this two-way pull. The market will fit whatever narrative as it breaks below 3000 or when it is above 3100 depending on the flavor of the day. But, what is really driving these moves around 3000?
There is a significant amount of open interest around 3000 to 3100. What this means is that market-makers do not know whether their options will be in-the-money or out-the-money come Friday. They have to hedge accordingly, and make sure they are flat post Friday. Since most of them are short this causes them to violently buy higher as the market rallies or sell lower as it falls - negative gamma hedging. Their aim is to keep the market pinned to a certain strike so they do not suffer the volatility.
There has just been one trade in town since the beginning of June, recovery or back to recession. The former camp catering to long cyclical stocks selling out of bonds, or the latter camp long bond proxies and short cyclicals. All asset classes and stocks including the dollar have been moving on that theme, violently up and down. There is no doubt that the market has been supported mostly by the Fed and their open-ended QE with buying up of Corporate Bonds of large U.S. corporations, even High Yield and Junk Bonds. The Fed has already gone where no Fed has ever gone before. One cannot fight this liquidity boost as it has and will continue to be a huge support for asset prices. The Fed cannot stimulate or produce GDP growth, but they hope to provide the market with enough support, buying time, such that the market can then grow on its own. This is their hope. Whether it will be a reality is a big question.
We know from past experiences, no matter how more the Fed adds in QE, it only supports asset prices but it is not generating the right economic growth. It is bailing out zombie companies which use the new money to pay down their old debt. The trend growth is slower and slower. Their hope is to stoke inflation as they have never reached their target of 2% over the past decade. Now, as they pump too much money in the system, it is quite possible we see a state of lower growth and higher inflation: stagflation! The truth is the Fed is petrified and they don't really know. They are just throwing the kitchen sink at the problem, hoping it goes away, but it does not really solve the bigger problem. Needless to say, asset prices will be supported, especially equities, as Daddy Powell keeps running to buy every instrument.
This week the market's true underlying trend is being distorted by the triple witching event. After this Friday the market will perhaps move to its real trend as it will not be whipsawed by aggressive futures trading. A lot of sentiment indicators are looking stretched on a daily basis. Despite the 7% pullback this week and the 4% rally, the Nasdaq hardly made a dent in its extreme overbought situation. Corporate profit margins are shrinking vs. their relative equity valuations.
July sees Q2'20 earnings in earnest, and it will be interesting to see if the valuations match the outlooks by the companies. If the Fed pauses or tapers its asset purchases now given how high we are on the markets, it can cause a bit of healthy profit taking. If the market falls drastically, we know the Fed can come back and announce they will then buy equity ETF's. We are in unchartered territory, anything is possible, even if it is not rational. One must not fight the liquidity but one must understand its relevance, especially when the market is disconnected from true economic reality. Let's call a spade a spade, if the Fed did not embark on their balance sheet expansion, the S&P 500 would be nowhere close to the level it is today.
