Week of Dec 23
Santa is squeezing down the chimney.
Recap of last week
We were one of the very few dumping our longs in November, anticipating December weakness. When everyone is expecting a January OPEX selloff, naturally it comes way sooner to catch people (most) off guard.
Now I did NOT force a -3% down day in the SPX on FOMC. Caught me totally off guard. As markets tend to do now and again. Although, taking that DD on a 1/4 size position pretty much softened most of the pain for us, and now we do have large amounts of cash ready deploy on this liquidation event. Was this it, bottom is in? Is Santa coming.
Next move for markets
Up. Santa is coming. He is squeezing into his tight red pants and I believe will crush the naughty bears this week. The first hurdle for me to get bullish was understanding the selloff. It seems obvious in hindsight (as it always does), but now that I am able to digest the market reaction and had the time to look at the market underneath the hood, I have turned pretty bullish. Let me break down what I believe to have caused the selloff.
Positioning. Positioning is always the tinder and FOMC was just the lit match tossed upon the pile. NAAIM was close to 100, BofA was showing record LOW cash holdings among asset managers.
Greed/speculation. We had a pitifully low P/C ratio for many weeks on end, TSLA had doubled in 2 months, MAGS was approaching an 80 RSI. Crypto. Alot of froth in the market.
FOMC. Not an accident to put this 3rd on the list, everyone was expecting a hawkish FOMC, but I believe it was just the first domino to fall, in a more balanced market I think that the same FOMC would have resulted in a much more muted down day or even upside day. People always attached the narrative to fit the price action and that’s a trap to avoid.
Dealer positioning. I have been harping on and on about dealers stuffed long gamma, the JPM short call strike at 6055. We had basically not moved much for weeks on end so this underscored some structural weakness. As soon as we broke away from this strike, we accelerated fast. Dealers got ripped away from their long gamma, speculators pressed the move once they started seeing some movement, and you saw many left for dead puts suddenly come back alive and with that dealers had to actively delta hedge by shorting futures.
Systematics. The CTA community has been dormant for months now, as we have steadily maintained ES1 over all major systematic triggers. Until FOMC day. All the previous factors in play, were able to push ES below the short term sell trigger and it was just gasoline on the fire.
They dumped tens of billions of SPX futures amidst the panic selling, which put more puts ITM, which attracted more momentum players, and it all created a massive squeeze, downwards. Also let’s not forget the massive volatility spike, almost +70% in one day. Which brought vol control funds also massively selling into the liquidity vortex that was December 18th.
Hedge funds. Of course hedge funds joined the party as they love a good shorting spree. The market was already down for the count because of all these different factors, and then HFs joined the free and pummelled it into oblivion.
They shorted stocks at a pace in the 100th percentile, on a 5 year loopback. I know we get inundated with charts all the time these days, but if you refer to the above, they shorted stocks at the fastest pace since the COVID crash. When the economy was literally shut down across the entire world, when you weren’t allowed to leave your house in many developed countries, when they shut down the NBA… You get the point. Does a couple dots on a piece of paper moving around really get the same treatment as the COVID crash? I dont think it deserves that same reaction. Again I believe it was a perfect storm of bearish factors that coincided at the perfect time.
These factors are the main impetuses for the market to puke that day. I believe it was a perfect storm. Meaning price traded unfairly low that day and into the end of the week. The market got caught with its pants down, and smart players gobbled up that supply. And so I believe the bottom is in, as many of these factors can/will not be repeated, and in many cases the flows that pushed the market lower, will in time push it back higher.
The boomer index is so back baby. The Dow Jones has led the correction downwards and will be the first to recover. After an unprecedented 10 down days, culminating in a blow off bottom, it’s safe to say most of the damage is behind us. Not to say it’s a straight line up until January, there may still be a wobble or two, but I think we fulfilled most of the necessary conditions for a nice correction. As you can see RSI dipped below 30, which is quite rare for the Dow. Last time it happened (not shown) was in October 2023, which was also a very significant bottom if you recall.
There was some decent technical damage done on Wednesday, and we are not fully out of the woods yet. CTAs flip to selling this week in all scenarios. They will likely cause a wobble, and may result in some weak closes or a down day or two. This is to be expected. Although I do not expect a retest of the lows and we should see some higher lows and higher highs as we move throughout Christmas week.
On the other hand, now that these guys have sold, and are selling they will at one point in the near future have to flip back to buyers, should we continue higher. Which I believe we will. So it’s important to remind ourselves that corrections actually strengthen and further extend an uptrend. We transferred equities from weak to strong hands, and many new buyers have a much lower cost basis which will make it easier to hold and contribute to some more stability in this new leg of the uptrend.
Hedge funds had their fun last week, now the bill comes due. Everything they shorted they will have to buy back.
HFs took down gross/net exposure quite substantially last week. Should the market move higher here, they will be in a frenzy covering shorts and getting back long again. That was a very fast, very vicious move down, and will likely reflect that same pace on the move back up. In many measures they sold stocks at a pace not seen since the COVID crash. If you remember that period like I do, like it was yesterday, it was a crash and a rally for the ages.
So in essence coming into this week, we are sort of discovering what caused the unwind. After the unwind last week, will be the unwind of the unwind this week
It certainly felt like a long week last week, let’s not forget where we are on the seasonal roadmap. We are still in the midst of the strongest 4 week stretch of the entire year. That has not gone away. Yes we had the liquidation in its midst, but that doesn’t cancel out the bullish factors. They are still at play. Early January will bring the biggest inflows of the entire year, and late December is when folks will be front running that. I would also argue that the ~5% flash correction we just had will bring in many new buyers. Many wanted a bit of a shakeout/retracement to buy and we just had that. Not many had the balls to pull the trigger of course, but that’s a different story for another time.
On breadth, we had one of the worst stretches of bad breadth in the history of the stock market. I am sure you have read all about it from various sources so I will not waste too much time rehashing it. On the bright side of that, mean reversion is a very powerful force of nature and by many metric we have just absolutely bombed out to a place where the easiest path is upwards. Unless the Fed releases a new dot plot every day now, my guess is stocks will naturally rebound from their deep oversold conditions.
From Daily Chartbook on Twitter, as you can see by this measure stocks underneath the hood were oversold in ways not seen since the last bear market. It is hard to overstate the carnage we have seen in the S&P 493. I think its safe to say the worst is over.
To sum up, last week the market experienced a perfect storm of bearish events, all culminating in a perfect climax of a blow off bottom on Wednesday-Friday. The biggest options expiration of all time, Dec 20th was likely the last thing holding the index down as all those suddenly ITM puts expired/exercised. Looking forward into the next week and end of the year, I believe we will see an unwind of the unwind, where Hedge funds have to ferociously cover shorts and regross exposure. Now that the dust has settled, the unwind of the largest short selling spree since the COVID crash will require a very large and substantial buy flow spread across the Christmas week liquidity which will have an outsized impact. Technically speaking, the correction strengthened the underlying uptrend as new buyers acquired equities at more favourable prices, and we also gained new future buyers as CTA and Vol Control are now back on the horizon in a “Buyers live higher” tape. So much to say, let’s not forget we are in the midst of the most bullish 4-week stretch of the calendar year. All in all, this looks to me like a shakeout before the market rips higher. The Grinch tried to steal Christmas but I believe he has failed.
Trade Ideas
We remain well positioned for a bounce back through Jan/Feb calls in RSP, XLF, SPY.
Wishing you all a Merry Christmas!
