Updated: Aug 7, 2022
Hey Traderade family! It's been a very interesting week. Let's take a look underneath the surface at what's going on, why it matters, and where we may go from here.
VIX: Volatility has been discounted this week rather significantly, but it remains somewhat expensive. Implied S&P 500 volatility is reading 21.15, but one month realized volatility is at 19.25, suggesting that the market remains relatively well hedged.
HY spreads: Corporate high yield spreads have been falling, from a high of about 600 bps all the way down to 455 bps now. That 145 bps discount is meaningful as it illustrates an easing of financial conditions as well as risk taking in lower quality debt.
NYMO: Breadth has been deteriorating since we reached 88.91 on July 29th. This is generally bearish, and as we've seen with previous rallies they tend to top out as breadth deteriorates, but we see signs of extremes elsewhere.
CBOE equity put/call ratio: The CBOE put call ratio ended the week at 0.58, which isn't an extreme, but what was extreme were the amount of delta-driven short squeezes on Thursday and Friday. Unprofitable companies that have little chance at surviving longer term rallied the hardest. Many of which had alarmingly high short interest. Some even had few to no shares available to borrow at several brokers (thinking of BYND, MSTR, RDBX, etc). The last several times this type of action played out it was close to an interim top. Will this time be different? Time will tell.
NAAIM: Managed money is yet again buying the rip, a practice that hasn't worked out well for them for the majority of 2022. Many are employing leverage as well, setting them up for forced and potentially disorderly exits should downward pressure increase.
Rydex Bear/Bull: We're seeing complacency come back to these Rydex managed funds, which tells us fear among retail is dropping. When we combine this with everything else we're seeing it tells me that there is a lack of appreciation for the inherent risks involved with this market environment of recessive economic growth and tightening financial conditions. Add on top of that central banks which seem intent to continue tightening those same financial conditions globally.
While S&P 500 implied volatility appears a bit expensive when viewed through the lens of RV vs IV, there are signs that US Treasury market volatility may pull the VIX higher. We can see the spread in the MOVE index vs VIX is the widest its been since the Great Financial Crisis. Often is the case that credit market volatility drags higher volatility in other asset classes, including commodity, currency, and equity markets.
Going in to last week we saw leveraged shorts continue to increase their negative exposure, while asset managers and dealers increased their positive exposure. The leveraged shorts were forced to exit some of their positions in lower quality speculative growth, tech, and biotech firms late in to last week. I wouldn't be surprised if they also decreased their short positions in equity futures as they flattened their books as well.
The bulls are back, as we can see sentiment has bounced meaningfully from its lows. This tells me that we aren't at an extreme that suggests there's more room for mean reversion on the basis of too many being caught off sides short or in cash. Meanwhile, bearishness has dropped a bit, but not too meaningfully. Ultimately this is a reading that neutralizes the extreme in negativity we had seen leading in to this countertrend bounce within the context of a larger bear market.
The biggest driver of the prior 13 year bull market was an abundance of liquidity and very, very low real rates. We can see the strong positive correlation between the aggregate size of major central bank balance sheets and the performance of the S&P 500 over this same time period. What's the big take away? Now that QE has become QT we are entering an era of scarcity. Liquidity is being drained from the global financial system and this is a major headwind for stocks.
The spread between 10s and 2s is at the deepest inversion in about 22 years, which isn't just an indication that debt market participants are increasingly concerned about a recession, it also shows that they are similarly vexed about the growing likelihood of a Fed misstep.
After that seemingly scorching hot July jobs report, we saw Fed funds futures forecast a 68% chance of a 75 bps hike in September. Similarly, Fed speakers have been expressing themselves in an increasingly hawkish tone. Suggesting that they aren't anywhere near a pivot point in interest rate policy. The current terminal rate range is projected to be 3.5-3.75% and achieved later this year at the December meeting.
While financial conditions have seen some easing of late, they remain quite tight from where we were during the last countertrend bounce, suggesting that some of this rally, especially within longer duration risk assets, is living on borrowed time.
The majority of long duration assets have seen a globally harmonized deleveraging this year, and this latest rally still appears to be one within the context of a broader multi-asset bear market. Whereas the driving force behind their declines remains well intact: central banks tightening, especially within the context of deteriorating economic conditions. Without an abundance of liquidity and negative real rates, a lot of these assets are likely to be sold lower in my view.
We remain within a bear market with the potential for more downside. The current countertrend rally appears to be running on fumes. Managing risk carefully is recommended here, especially on the long side.