While we wait to see if vol-targeting funds suffer another late-day meltdown and liquidate in the last hour of cash trading into the higher vol regime, stocks have stabilized (following another sharp overnight selloff driven by China, where stocks tumbled to a fresh 4 year low) largely thanks to a collapse in rates vol as unchanged 10Y rates provide a pillar of stability for equities. That said, as Nomura’s Charlie McElligott writes in his latest daily piece, the S&P remain susceptible to the previously noted “gamma-gravity” resulting from massive S&P open interest with 2750 and 2800 strikes (the S&P is trading inbetween these two levels at last check, just above 2,760).
Meanwhile, despite last week’s late rebound, systematic selling continued on Friday and into Monday with another -$7.8 billion of notional SPX selling, with Nomura calculating that CTA Trend positioning in the S&P is now just +35.9% Long from Friday’s +45% and a far cry from the +100% Max Long from two weeks back.
So with the systematic purge largely in the rearview mirror (even if Barclays still expects some substantial leftover selling from the slower-vol funds), and with factor chasers and hedge funds having largely completed their rotation – with substantial P&L losses – out of “momentum” as crowded multi-year legacy “long Growth, short Value” positions blew up on Wednesday – McElligott writes that he remains “of the view that there remains real scope for a tactical Q4 risk-rally” for the following 5 reasons:
- positioning is much cleaner now that this “wash out” has occurred, especially with so much “short” added over the past two weeks (“fodder to squeeze”);
- the return of the “corporate buyback” in coming weeks;
- the “low bars” being created by “negative EPS revision” trend;
- inverted VIX curve as contrarian “bullish signal”; and
- typical Q4 seasonality, especially off the back of the mid-term U.S. election cycle +++ analog studies
Yet even as traders look beyond the near term, wondering whether the S&P breaks out below or above the “gamma gravity” well of 2750-2800, they are starting to turn their attention to the longer-term, where storm clouds are gathering.
Specifically, as McElligott writes, a funny thing happened with that whole “extending the end-cycle into 2021” phenomenon seen just two weeks ago from investors (and discussed in “This Is Telling Us Something Powerful About The Market’s Sentiment”), as the “accelerating angst” from the post-Powell presser “Fed is going to hike until something breaks” worldview has quickly overridden the recently “hot” U.S. data.
As shown in the chart below, McElligott notes that “we are now again “only” pricing-in 52bps of hikes for 2019 vs 60bps just two weeks ago—and all “short” of the Fed’s 75bps projections, as the buy-side is consensually skeptical of the Fed being able to implement tighter policy without slowing the “real economy.”
Why is this latest reversal important? Because that is the qualitative “psyche-shift” McElligott has been warning about for much of the summer:
investor psychology is transitioning from a “we are growing faster than we are tightening” view (risk-POSITIVE environment experienced majority of 2018) to the dreaded “we are tightening ourselves into a slow-down” (the risk-NEGATIVE / “Fed Policy Error” outlook), where markets “pull-forward” their end-of-cycle timing expectations
Meanwhile, recent comments from Powell, i.e. his willingness to “…go past neutral” and run outright restrictive monetary policy – have not helped, as the Fed’s increasing “data-dependence” means an “asymmetric bias to react to positive data more than negative data”, i.e. the risk of “too good” U.S. data means risk of FOMC “over-tightening” (it is hardly a surprise that investors are eagerly looking forward to this Wednesday’s FOMC minutes for further validation of this downside risk).
This is why the Nomura cross-asset quant says that he remains “on plan for the early-to-mid 2019 risk-off trade, as per my original “Two Speed Year” thesis—I believe the Fed will likely only “get in” two / three more hikes before a “vigilante” market likely forces Fed to “pause”—and by then, that’s the market’s “signal” to de-risk as it “sniffs-out a slowdown.”
This bearish thesis also converges with the outlook of Stifel analyst Barry Bannister, who one month ago wrote that just two more rate hikes would put the central bank above the neutral rate: The Fed’s long-term projection of its policy rate has risen from 2.8% at the end of 2017 to 2.9% in June. The September rate hike followed Bannister’s note, so as of this moment just one more hike would be sufficient to push the fed funds rate beyond neutral. And, as shown in the chart below, every time the Fed hiked beyond the neutral rate, a bear market has inevitably followed.
Echoing this point, last week UBS calculated that financial conditions have tightened significantly, delivering the equivalent of 25bp Fed hike in October, and 80bps, or over Fed 3 hikes, since February, after years of unexpectedly loose financial conditions in which the market stoically ignored the Fed’s rate hikes.
Commenting on this, McElligott notes that as per his “Financial Conditions Tightening Tantrum” phase 2, the attributes are everywhere across U.S. Equities as “late-cycle canaries” are being crushed and the market “sniffs the slowdown” via tighter financial conditions, listing the following stark examples:
- S&P Autos -30.7% from Jan highs
- S&P Homebuilders -34.3% since Jan highs
- S&P Semis / Equip -14.5% from Jun highs
- S&P Regional Banks -14.6% from Jun highs
Finally, in a tangent on an asset class that the Nomura strategist is increasingly warming up on, McElligott continues to see the risk of explosive upside for gold – an asset which was a “placeholder short” for the past year, with Friday’s CFTC data showing a new record “Net Short” spec position,and which is now approaching the point of “capitulatory/forced-buying” from within the “price-insensitive” systematic community.
So if the short squeeze finally kicks in, how much gold buying could one expect, and above what price? The answer: a lot, and the threshold price is anything above $1,228.
The CTA Trend model currently shows that a Gold close above $1228 / oz today (currently near the “strike zone”) would trigger VERY substantial covering flows—taking the current legacy “Max -100% Short” to just “-12% Short” to the tune of ~$39B of buying
Could this be the fateful moment – one where stocks continue sliding as gold finally soars – that so many precious metal fans have been patiently waiting for every since gold peaked back in 2011?
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