Altered Beast

Just from looking at the intraday SPX futures movements, quick 10 point moves in a few minutes are happening randomly without much volume.  That didn’t happen earlier this year.  The danger in the market is palpable.  This is not your Jan 1 to July 12 market.  Its a different beast.  From a calm creature to a wild, savage one.  An altered beast.  The HFTs are no longer willing to provide a lot of liquidity because the long term buyers are not there to support the market.   This higher volatility is coming off a stretch of very low realized vol, which has bred a lot of complacency in the market.  The vol control funds are near max long exposure, but will be paring their exposure fast as the higher realized vol readings will force risk reductions. 

 

In the options market, you don’t see as much put hedging or short selling as you did in the past.  That means investors now are more naked then ever, similar to levels that were last seen in 2000.  Its uncanny how much this feels like late 1999/ early 2000.  When investors are not well hedged, they are more apt to panic on sustained selloffs.  Emphasis on sustained.  Since these conditions happen during uptrending environments, short selloffs are not met with panic, because of the built in complacency.  The threshold to panic increases, but that also increases the magnitude of the panic when it does eventually happen.  Like the vicious down moves after hitting all time highs in the spring of 2000.  Or even the January to April 2018 convulsions near all time highs.

Investors and traders have been conditioned for the last 15 years that the market almost always goes up.  That bear markets can be scary, but are brief.  And that it always comes roaring back to make new all time highs.  This is what happened from 1982 to 2000.  But what is scarier this time is that unlike the 1982 to 2000 time period where you had massive technological productivity gains, from 2009 to 2024, all you’ve had are small, incremental gains.  The smart phone, data centers: centralizing storage and outsourcing servers, and now pie in the sky AI, have proven to be a drop in the bucket compared to faster CPUs and the internet.  

Most of the gains from the 2009 to 2024 bull market came from higher profit margins due to much lower bond yields, higher valuation multiples, oligopoly rent seeking, regulatory capture, and the government blowing out its budget to increase demand.   Those are not repeatable in the next 15 years unless the government and the population are willing to tolerate high inflation and even more inequality.  Low inflation and repeating the 2009 to 2024 money spew out of the US Treasury and Fed are not mutually compatible.  A 2000 to 2002 style bear market awaits. 

On Wednesday, they got what they wanted.  A Fed that made wholesale changes to its FOMC statement, basically paving the way for a September rate cut.  The market is always ahead of the Fed, sometimes too far ahead.  But unlike the December 2023 pivot, the rate cuts are coming this time.  The STIRs market is most accurate for the next 2 meetings, and beyond that, much less so.  SOFR and Fed funds futures never priced greater than a 50% chance of a 25 bp cut at the next meeting anytime after the December 2023 pivot.  After the weaker jobs claims data and ISM number, its pricing in 32 bps of cuts for the September meeting.  It means that the market expects 25 bps, but thinks there is a 25% chance of 50 bps cut instead.  

I don’t think we sold off yesterday because of weaker economic data.  It just went up too much yesterday on Fed hopes and call buying and that reverses quickly if the long term money isn’t there to support the higher prices.  

Reporters AND traders are always trying to find a reason for a big rally or big selloff.  The big rally on Wednesday was a combination of short covering and anticipation for a bullish reaction to the Fed meeting.   Based on what I have seen on Twitter, the eagerness to call a bottom and to catch a rally is quite common.  That is corroborated by the relatively low put/call ratios throughout this 2 week selloff.  That is uncommon.  And a big warning sign.  As well as the COT positioning data that showed small speculators getting longer into the weakness last week.  Asset managers barely flinched during last week’s selling.  They are usually reducing longs as the market goes lower.  Despite the violent selling, not much has changed regarding postioning and options flows.  Yesterday was the first day where you actually had muted call buying and some more puts bought, but its still not close to the levels seen at the April lows.  

Tape reading is overrated these days because short term patterns have changed from the past.  You never had so much short term options speculation.  Intraday, the tail is often wagging the dog.   Call speculation is driving many of these spastic moves you see these days.  So much of these flows are short term in nature because of the popularity of short term expiry options.  Dealers have to hedge these flows.  When a bunch of OTM calls suddenly get closer to the money during a rally, like on Wednesday, the gamma squeezes are intense, and lead to exaggerated up moves that are not supported by longer term, stickier flows.  So you get payback and vicious mean reversion as the artificially high prices bring in longer term sellers and there is an air pocket underneath.  

Apparently a 270 point SPX selloff over the past 2 weeks wasn’t enough to scare the crowd.  We may need a 400 point selloff from top to bottom to finally see the call buying subside and for the put buying to really pick up.  I will remain max short until I see much higher put/call ratios.  Its tempting to try to microtrade and catch all the short term moves, and to try to avoid drawdowns.  But that often leads to taking profits too early and missing the big sustained moves.  I expect sustained selling for the next few days as we get closer to the pain threshold for the longs.