Week of October 6
SPX losing steam?
Recap of last week
Good week for us last week. Slightly green on the week with winners in both ES and some risk reversals we put on in September. Very volatile week so happy with that.
Last week in the weekly post we said bottom is in.
On Tuesday said new highs are coming. We got that as well. On Friday we tapped 6800 on ES then closed pretty much on the lows. Quite bearish daily candle. Correction watch?
Next move for markets
Up. I don’t put much stock into any weakness above 6730s on ES. Its a very solid breakout as of last week, there is no clock for the bulls to push higher or anything as long as they hold that level. Very often you see breakouts sort of meander above the previous resistance just puttering around, then one day they just take off and rip faces. That will always be my base case. If bears are the real deal they will close this below 6730. Plain and simple. Until then, I favour continue playing the upside.
It’s time to start thinking about year-end. Everyone from asset managers, to C-suite execs, to hedge fund managers are thinking about the same thing. How to maximize return for themselves and stakeholders as we finish out the year. The theme of the year is lock-out rally. Everyone was bearish on the market and economy due to tariffs or TDS or what have you. The crowd in aggregate refused to buy in the market in the 5000s, and now they are forced to buy back in close to 7000. You see this reflected in the year end funding premium for the S&P. That’s one of the best ways to measure professional demand for long exposure, and is quantifiable based on actual costs spent by money managers rather than bullshit surveys that a monkey could fill out and no one would know the difference. Demand is very high for US stocks right now.
As investors we always must think about where we can be wrong, or if there is any reasonable risk/reward to fading the consensus. I think some areas to atleast acknowledge some potential risks are:
Inflation - CPI/PCE is our main touchpoint on this. Delayed indefinitely due to government shutdown.
Economic weakness - We will use NFP is the best proxy. Delayed also.
Federal Reserve - Dovish, embarking on a cutting cycle.
Executive Office - Determined to ramp stocks higher.
I really don’t see the bear case on these main pillars that are driving stocks right now. Valuations don’t matter in the short term. I think you want to avoid the mental gymnastics and swim with the tide here. We are already positioned for this with the risk reversals and looking to buy dips almost everyday. Still I am ready to pounce on any dip with options in case we get a decent dip as well. Would love to be more long, but I am sure a better opportunity will present itself sometime this month as October is statistically the most volatile of the entire year. This is largely due to 3Q earnings as companies either meet or fall short of their full year guidance. Big fiscal year end of mutual funds. Also the last real month of the year where liquidity is plentiful for big asset managers to shuffle around positions.
I know I sound like a broken record here, but the story hasn’t changed. Humans are stubborn. They don’t like to admit they are wrong. Still to this day, as the market melts up seemingly non stop, there are no signs of euphoria in this market. Another one of my favorite real money indicators (as in non survey based) is put/call skew in the S&P. Right now certainly people are pounding calls, but the price of OTM calls is still rather muted. We have seen much more demand for these in recent times, most notably last November/December when Trump had just won the election. The fat purple line I drew is where I would be more cautious and expect more turbulence and an imminent pullback. As I stated before, the underlying pillars of this market (dovish Fed, strong GDP, subdued inflation, great earnings) and very much intact. So to get a more sustained pullback you need to see more euphoric positioning, or else some sort of black swan. Otherwise, its more of the same. Slow motion melt up.
What is kind of shocking, is instead of seeing euphoric call buying after such a massive 35% rally with a rVol of around 10 since the April lows, is that the crowd remains overly fearful. I have been talking about this alot this year, vol is not cheap because its mid-teens. You have to look at the ratio between implieds and realized. If VIX is implying a 70bps daily move and you get 35bps realized, thats expensive. Yet so many people only look at spot VIX and make a determination solely based on that value independent of realized vol. It doesn’t tell the whole story. GS has flagged that the 1m variance swap (implied vol) vs what the S&P is realizing today as one of the biggest gaps since 2017.
Put very simply, the price of options in the SPX right now are too expensive. The absolute price of options is cheap, but the movement in the index is under 40bps/daily over the last month, so they are not cheap enough. The best way to play that is of course to sell options. We have already done so, being short both the 650 puts and 720 calls on our risk reversals.
Some other good ways to play this is by selling 0dte puts, or iron condors, or ATM 30d puts. It is a very consistent way to make money in this market, only drawback being you need alot of capital to make smaller returns vs outright long delta in futures/options but wanted to remind people as its still a great opportunity.
GS has run the backtest on previous similar instances where you saw such a big gap between implied and realized vol. The forward returns are pretty outstanding. The last time I posted a similar vol study back in my “Week of April 21” post, when the SPX was 5158.
The excerpt above. SPX is now 30% higher. In very simple terms, market participants are over hedged currently, they are scared of some boogeyman. If this uptrend isn’t broken forcefully, what will happen is these hedges will melt away and the decay of the puts will spur more dealer buyback of hedges pushing up index prices even further. With the actual SPX movement we are seeing, VIX should be in the low teens right now, not 16-17 ish which is what we are seeing now.
On Systematic positioning, nothing really new for us here. They are close to max long, but are not much of a factor unless we were to drop significantly from here.
Similar story with buybacks, most corporates are in black out right now as we approach 3Q earnings reports. Earnings season kicks off as usual with the big banks in the next week or two. As usual, once they conclude reporting they will open up for buybacks again as we approach the holidays.
What is notable here, is in the absence of huge buyers (systematics, buybacks) the trend for SPX has not really buckled. That is a profound sign of strength. What happens when they do come back?
Last but not least, as we embark on this Fed rate cut cycle and talks of a stock market bubble are everywhere, I think it’s worth looking at whats outperforming the most. As always the focus for me is the ES/SPX, but if we start to enter a 2021-like market regime again alot of junk will start flying. The biggest hedge fund factors right now that are delivering huge returns are crypto, quantum computing, most short, and non profitable tech.
To sum up, the slow motion melt up continues. I don’t see a reason to even think about thinking about short until we close below 6730 in ES. Although the Friday candle was weak, the onus is on the bears to take us below there else we just float back up to retest 6800. We have about a week or two before earnings season kicks off in earnest. I am on watch for a potential October mini correction as it tends to be very volatile in years past, but right now hard to see something major as there is no NFP, no CPI, no PCE until the shutdown is resolved. We will continue buying the dips for now.
Trade Ideas
Will alert in the chat.