Most market participants are obsessed with the level of the S&P 500 and constantly obsessing and philosophizing about where it is trading or should be trading. Truth be told, it is one of the most complex beasts in the market, given the range of money and funds that are exposed to it. Hence its "natural" behaviour may not be logical at times despite what the "fundamentals" imply.
Imagine an index that is bought and sold by individual investors, mutual funds, Hedge Funds, corporates, derivatives teams and momentum speculative traders -- all with different mandates and time horizons. At any given point in time, you could see a barrage of different people pushing and pulling the index at the spot level. Perhaps it is better to take a step back and observe what is happening underneath the surface, across sectors, to really understand the mindset of the market.
One of the most important factors influencing the behaviour of the S&P 500 is the technical derivative positioning. Institutions and banks hold massive derivative positions, both calls and puts (which we call being long volatility) as a hedge against their equity exposure. Their purpose is to be long calls to get access to upside if the market breaks out, but only allocate a small portion of its capital in case they are wrong. Alternatively, to be short puts as they seem worried about how much money they are making on the market rallying, and want some protection of sorts.
These are just sympathy trades done to appear as though they are protected in case something happens. We all know that if the market were to collapse, these puts would do nothing to offset against the massive naked long-only equity positions, but it does keep the risk department at these funds happy. What all this means is that there is significant delta and gamma exposure based on those heavy volatility net positions around key strikes in the S&P 500.
According to a recent note from Nomura's Charlie McElligott, the combined net option position in the S&P 500 shows a long gamma exposure around key strikes of 3100 and 3150. We have seen a torrent of headlines from deal-no-deal to impeachment-no-impeachment, to tariffs roll back-signing of HK bill -- an avalanche of headlines that would expect to cause the S&P 500 whiplash up and down at least 2%-3%.
But why is it so stable? Derivative positioning. Market makers on the whole, given the long exposure around these key strikes, need to buy futures below these strikes and sell futures above these strikes to risk manage their books. This means the market will never break away from these strikes, currently pinned around 3100, until a big macro shock takes place, forcing a flurry of one sided flow taking us to the next strike of exposure.
In this note, Charlie goes onto explain that this "long" exposure does not change until we get to 3055 or even 3030. In layman's terms, this means that if we were to get a serious shock to market, aggressive future selling could take place very fast as we flirt with the 3055 level, as the market makers will start getting very long the market and will need to sell relentlessly to be balanced. Of course, the average trader has no idea about volatility and its complexities, the media will jump to add a narrative to any move to justify some commentary for these moves. One needs to be mindful of this and take a view on what is happening and why, as opposed to chasing the move and getting caught out.
The market can very well be stuck at 3100 for now going into winter even. But something very interesting happened a few weeks ago and there are hints of it still being in place -- sector rotation. After Powell's October press conference, cyclicals and laggards of this year have outperformed defensive stocks. Bonds have gotten crushed as 10-year yields spiked back up to 1.90%, taking long gold and cryptocurrencies like Bitcoin down with it too.
The "safe-haven" trade has started to be unwound -- and that seems to be continuing. Cyclical sectors like Banks, Energy, Commodity-exposed Mining stocks and Industrials have all bounced as the short position is slowly unwinding. The oil price, after trying to break $60/bbl Brent, has rallied back to $63/bbl now as we enter the seasonal winter demand period. This will provide support to the oil market as distillate demand is expected to pick up in the next few months.
Energy has been a perennial under-performer, for good reason, but as we head into the Thanksgiving period, which is the "unofficial" year end for a lot of funds ahead of an uncertain December, it might be prudent to start locking in some profits of 2019. Technology has been the winner this year, with all its massive cash flow growth and buybacks, whereas Energy has been the worst performer given the oversupply that has plagued the oil market all year.
We know Energy stocks are cheap, they always have been. But right now, there is a case to be made for oil stocks to start depleting going into winter, especially if OPEC+ cuts remain in place. This can be motivation enough for funds to start selling technology, Utilities and Consumer Staples to the benefit of Energy and Commodity-oriented stocks. What can add fuel to the fire is if we start seeing growth economic data start to point upwards after all this central bank easing around the world, with the Fed and PBOC now joining forces too.
