I hope everyone has had a good weekend so far. I wanted to write a quick note about shifting behaviors in the market that we've been seeing this year.
The COVID crash led to the largest and fastest coordinated monetary policy response in history. That flood of liquidity and reduction in the cost of capital caused a massive leveraging up into speculative risk assets, and that leverage can be seen in the massive rise in margin debt from 2020 until late 2021.
But as rates rise and liquidity is being drained from the global financial system, it becomes more costly to hold margin debt. This encourages deleveraging, which we can see has been a trend in 2022 as the Fed has been more and more aggressive regarding their tightening stance.
As reductions in margin debt occur, we see further downward pressure on equities because many utilize margin debt to speculate on stocks and options.
While margin debt has fallen quite a bit in 2022, it's likely there's further downside from here as we can see there's been a large drop in M2 money supply, which corporate debt followed.
On the way up we see that money supply led both corporate debt, and later margin debt higher. I think it's reasonable to say we'll see the inverse on the way down as financial conditions continue to tighten, encouraging margin debtors to reduce leverage by further derisking their portfolios.
Meanwhile, in the world of options we're seeing a noticeable drop in call volume and a surge in put volume. This suggests that there's increasing negative sentiment from retail in single stocks as S&P 500 put skew remains subdued, but single stock put skew is the highest I've seen since the COVID crash.
We're witnessing one of the most significant deleveraging events in recent history coupled with a significant positioning shift within the single stock options market. This all suggests that we're in an environment that is likely to be even less liquid and more volatile than what we've already seen in 2022.
I think Friday's OpEx madness speaks to some of what we can expect to see, both on the up and downside of this market, for the remaining months of 2022.
The net impact of further deleveraging, however, is likely to subdue the potential for longer term upside until financial conditions begin to loosen, stimulating risk appetites. Something we aren't likely to see in a meaningful and durable way until Fed policy changes back to loosening.
For now, we remain in a bear market where the intermediate to longer term trajectory is lower, but we are likely to have face ripping rallies that can burn shorts and leave longs feeling FOMO, wanting to buy the rips. Caution is still warranted on both the long and short side in my opinion.