“Tails Are Getting Crazy” – Nomura Warns Pullback-Risks Remain Due To ‘Sentiment & Positioning’ Overshoots

There are three main dynamics in the markets currently as we head into year-end (and more imminently, next week’s quad witch):

1) Technicals – increasingly illiquid markets and tight risk management impact on “tails”

2) Near-term sentiment- and positioning- “overshoot” risks versus…

3) The ongoing tailwind flow- and narrative- driven risk-on catalysts into Year-End.

Nomura’s Charlie McElligott outlines all three below before suggesting a “muddle through” solution to asset allocation amid this chaos.

Market Technicals are “getting a bit weird” warns McElligott:

VVIX / tails got a bit crazy and seemingly “overreacting” relative to the sub-1% move in Eq Index, which likely captures two dynamics: Dealers being unable to be short vol in any meaningful size into year-end, complicated further by continued weakening liquidity into the year-end—which is of course a function of the first “risk management” point for both sell- and buy- side

SPX and QQQ 1m vols moved higher on the selloff and term structures flattened in recent reversal of trend for all, while again, “tails” went notably “bid” with VVIX +15 at one points, YIKES

In addition, the standard year-end risk management “gross-down” exercise is enhancing the already well-established thematic “rotation” optics, as legacy shorts (much of which is concentrated in economically-sensitive “Cyclical Value”) are covered or turned “long,” while long-term consensual longs (“Secular Growth” / Mega-Cap Tech—aka “Duration / Bond Proxies”) continue to underperform significantly as they’re reduced outright, or used as source of funds; we have also seen monetization in tactical Eq Index / ETF upside in recent days (closing-out Calls / Call Spreads), further supporting this year-end “de-grossing” view.

But, the bulls are in charge for now on flow- and narrative-driven themes:

…it is clear there that the majority of investors remains in thematic rebalancing “chase” mode, as Cyclical Value- / Leverage- / economic “Renormalization”- plays all keep working from the double-whammy of “vaccine reflation + lame-duck stimulus” feel-good narratives (plus a mathematically certain “base-effect” to come in 2021 year-over-year inflation data prints after the pandemic shock is within sample)—over the past few days, we have continued to see ongoing bullish expressions to play for a short-dated pro-cyclical “risk-on” trades (some outright wing-y) in key “reflation” thematic areas:

• Gold (GLD) Call Spreads

• Metals (XME, RIO, VALE, FCX, TECK) Calls, Call Spreads

• Energy (XLE, XOP) Calls, Call Spreads and Risk Reversals (sell Put / buy Call)

• Large buying of Long Duration UST downside via Puts / Put Spreads

The same vol trades we’ve discussed for a long while now—“long Calendar Spreads” (short 2020 optionality / long early 2021 optionality) and “long Dispersion” (on the “into Cyclical Value, out of Secular Growth” rebalancing—which further squelches Index Vol) both just continue to print positive PNL

The other trade to note, and on account of my recent point regarding what looks to be the market’s underpricing the risk of dual Democrat “Blue Wave” shockers in the GA Senate Run-offs, is to own that Jan 8 weekly straddle, which has traded from ~2.7% implied move down to ~2.0%ish now, and seems too cheap relative to the potential for market thematic calamity under the hood within Equities (more “Momentum Shock” potential on Value / Growth “rotation”) but also too with the Rates and Inflation complex risks (deep OTM Payers, anyone?)

With polling still holding a Dem tilt – yet market still generally assuming GOP wins and maintenance of status quo “DC gridlock” (thus the recent “everything rally”) – a double Democratic Win in GA would completely reopen markets to unprecedented government deficit spending largesse and super-stimulus ($4T-esque) – which in conjunction risks lighting the sleeping macro giant of decade-long “INFLATION SKEPTICISM” on fire; Yet too, when considering these policies would then be paired with across-the-boards tax hikes and re-regulation of industry, we see heightened odds of STAGFLATION-looking trade thematic

However, pullback risks remain, warns the Nomura strategist, due to some unruly “tail-y” throw-overs into said January Georgia run-off surprise potential, and most are tied to “sentiment” and “positioning” -overshoots:

• The Nomura SPX Sentiment Index at 98th %ile since 2004 and extreme Call Skews (>90th %ile +) across pro-cyclical economically sensitive ETFs per region, industry and thematic—reeks over “overshoot”

• “Captain Insane-O” levels of speculative RobinHood YOLO’ing in near-dated upside buying in the retail favorites (SPCE 250k Calls traded yday, 5:1 ratio vs Puts; TSLA 1mm Calls, 2:1; NIO 385k Calls, 2:1; PLTR 340k Calls, 2:1), creating rolling “convexity events” from the collective “weaponized (short) gamma” impact of these option grabs on dealer hedging flows; but as seen in that Aug / Sep “Momentum Unwind” shock, “short Gamma” can cut both ways

• “Extreme long $Delta” from options owners in SPX / SPY (96th %Ile since ’13), QQQ (96th %ile since ’13), IWM (99th %ile since ’13) and EEM (94th %ile since ’13) ahead of Op-Ex, which could of course speak to enhanced risk of “accelerated profit-taking” next week into any pullback, especially in conjunction with aforementioned year-end “gross-down” to protect PNL and performance bonuses

So, having taken all that in – bullish investors (on flow- and narrative-driven risk-on catalysts), bearish investors (fearing extreme sentiment and positioning overshoots) both facing low (and falling) liquidity and increasing costs of hedging – Nomura’s McElligott thinks a realistic way to play for next year is frankly a “muddle-through barbell” which tilts towards economic renormalization, but also hedges you with duration-sensitivity on account of clunky and laboring recovery with periods of disappointing data taking advantage of the narrative crowding into the expected “reflation regime change” which will mean that the Fed stays “heavy handed” with QE / monetary policy.