Roger [00:00:00] Monday's sell-off had a lot in common with the volatility experienced on Monday the 24th of December 2018 and Monday the 23rd of March 2020, in that it occurred on the first trading day after an expiry. Both those previous dates were major market lows. So should we expect the same thing to occur on this occasion? That's The Big Conversation.
Roger [00:00:26] First it's worth looking at some of the statistics from Monday's sell-off and snap-back rally; nearly every other instant of the Nasdaq falling 4 percent intraday before rallying back to positive territory, took place during either the dot com bust of 2000 to 2002, or during the depths of the financial crisis in October and November of 2008. According to FxMacro, the last two occasions when the Nasdaq recovered from a 4 percent intraday loss were in 2008, and on one occasion the Nasdaq was 17 percent lower within three days, and on the other 18 percent lower after six days. According to a tweet from Brent Donnelly and Bespoke Invest, the average 20 day move by the Nasdaq after an intraday reversal, off a decline of 4 percent or more, was minus 3.7 percent. Also the lows on Monday, meant that the decline from the highs in terms of index points was comparable with a bust in March 2020. The Nasdaq has fallen nearly 2900 points from the recent highs. In 2020, the decline was just under 3000 points. Though a percentage change, 2020 was far greater than this year's move. So on the face of it, a snap-back rally of this magnitude has normally been followed by further losses. But equally, those previous examples were within well-established bear markets. Whilst today we are no longer at the highs and we have entered correction territory, there's not the same backdrop of a mature bear market. And that's why we should also look at Monday's move, in the context of the expiry. Now although we are looking through the rear-view mirror, it's worth revisiting the impact that option expiries can have on markets. On Friday of last week, I tweeted that, 'there's lots of gamma rolling off, shorts should be wary over the next few days, as this pressure is released. The end of 2018 was the first trading day after expiry, and the low in March 2020 was the first trading day after expiry'. Monday's price action has therefore happened before, and it will happen again. In fact, it's always worth knowing the dates of the main stock and index expiries. The January expiry we saw last week, was not one of the major quarterly expiries like we saw in 2018 and 2020. The quarterly expiries are March, June, September and December. But this expiry, according to some reports, had one of the largest notional of stock options of any historical expiry. Now we must reiterate, the build-up of options doesn't define the direction of the market, but it can act as an accelerant, if the market is already volatile when significant expires are approaching. On the day of the US expiry itself, index options expire in the morning, but single stock options expire at the close on the Friday, and this can leave an inventory overhang of positions that still need to be managed into the following week. Now all of these are generalisations, and traders have tried to predict market action around expiries for years, but quite often it's little more than a coin toss. But whilst this January expiry was not one of the major quarterly expiries, perhaps the real difference between January 2022 and those expires in 2018 and 2020 was the policy backdrop. Today inflation means the policy backdrop is significantly different from previous years, and that increases the likelihood that this wasn't a major low, like the ones we've seen before. Plus, the involvement of retail traders today also increases the chances of lower lows, which we'll come to later. But first, let's look at that policy backdrop. Now we're shooting this on the same day as the January FOMC meeting, and nobody is expecting the Fed to start tightening the cycle before March, but there is now a consensus that March will be the beginning of three to four rate hikes this year, with some analysts arguing for rate hikes at every meeting from March, and that would be seven in total in 2022. However, given the magnitude of Monday's intraday decline, there's also been this increased expectation that the Fed may choose a less aggressive line, based on their reaction during those previous post expiry lows. In the December 2018 Fed meeting, the committee increased interest rates, which is now generally considered to be a policy error. That was the last hike of that cycle, and the Fed had to quickly reassure markets in the light of the accelerated drop in the S&P. Their next actions would be to cut interest rates and expand the balance sheet once more. The circumstances in March 2020 were, as we all know, even more extreme, with the very framework of markets starting to unravel due to the rapid deleveraging caused by the pandemic. Now record rate cuts and open-ended balance sheet expansion were needed to help create the March 23rd low. But on both those occasions, the Fed was able to cite its growth mandate and support equities, rather than let the sell-off potentially undermine the economy. Today however, the Fed has also had to focus on inflation, and it would appear that inflation is taking priority over growth. Higher prices are a problem for everyone, whereas lower equities are not. Of course, ideally the Fed would want to have both higher equity prices and lower inflation. But arguably the policy mix during the pandemic has supercharged both. Therefore, it's unlikely that they can achieve their goals on price, without having to sacrifice some of that froth in the equity market. And one of the issues the market will have to grapple with is that inflation is a lagging dataset. And even if it's already peaked, it'll take a long time for a return to politically acceptable levels. Therefore, to tackle inflation, the Fed may need to continue tightening even if it's having a detrimental effect on equity prices. And eventually tighter policy and lower equity prices could combine to slow the economy, which historically has capped inflation. Now recession is not the base case, but it does appear that the current business cycle has been significantly shortened. Growth markets should be doing well if inflation is a reflection of real growth. The Korean and Japanese equity markets have not been performing particularly well. The KOSPI has struggled to outperform the US market year to date. In Europe, the relative performance of the European industrials sector versus the broad market, is continuing to break down. The sector has had great absolute performance until recently, but if that's now over, then we are moving into the later stages of the cycle. And in Tuesday's European rally, one of the worst sectors for long-term relative performance, the telecoms sector, was significantly outperforming the market. Which is hardly a ringing endorsement, of a market rebound. So although we've seen a clear rotation within the equity market from that growth to value, many of those value sectors have actually fallen in absolute terms. The broad US equity market itself has been struggling with yields approaching 2 percent. Remember, that's well short of the 3.2 percent that halted the rally in 2018, and that indicates just how susceptible risk is to these higher rates. Furthermore, whilst bonds have been trying to rally through this burst of risk-off sentiment, the rally has not been sufficient, to offset the equity losses. Bonds have been moving in the expected direction, but not by the required amount. And that's going to make equities vulnerable to outright liquidation, if bonds are offering little protection. And volatility has also increased across the curve, which has shifted higher, pushing up the costs of buying protection. Persistently high volatility will eventually lead to a reduction in the equity allocations of the rules-based funds, which use volatility, is a major input. And within this framework, the impact of retail may become the defining factor. Back in 2018, retail investors were largely absent from the market. The main equity buyers were pension funds and the corporate buy back bid, and these were largely dispassionate market participants. Active investors were being crowded out by these passive elements, where rules-based investing ignored many of the traditional inputs, such as valuation. Therefore, once markets had stabilised at the end of 2018 and early 2019, the equity buyers returned to their rules-based investing. And the good news today is that these rules-based investors have never left. They remain on the bid whilst the corporate buybacks are now kicking back in as we move beyond earnings season. Since March 2020, however, retail investors have become a significant factor in equity markets. Having established a foothold through interest in Tesla, at the end of 2019, retail activity exploded on the scene during the pandemic, with stay-at-home investors fueled by fiscal support, easy access to markets and trade ideas, and that motto, amongst many others, that you only live once. Option volumes in particular, call volumes surged. We showed this chart last week of call open interest and the S&P, showing how volumes had mirrored the move in the market. Inflows into equity funds also reached record levels. But had the tailwinds for retail now peaked? Many of the favoured innovation stocks saw the surge in volumes coincide with a peak in performance, and many of those investors will now be looking for exits, if the stocks rally back to their entry levels. And when we look at call open interest in isolation, we can see a huge drop off in volume. Now this has happened at the beginning of each year, but this drop off is spectacular in comparison to previous years and the decline in volumes had already been in motion during previous months. Retail investors have not been replacing call exposure at the same rate as before. Unlike the rules-based investing that dominated 2015 to 2020, retail investors are emotional actors, who are more likely to sell rallies. And so far in January, we've see more rally selling than usual. Now that may have reached its peak with the expiry now behind us, but the involvement of retail reduces the chances that we get the straight in and out again dips like we saw in 2018 and again in 2020. Historically, markets that saw steep declines usually saw a 50 to 62 percent retracement before then rolling over to new lows in a three wave pattern. But this has been a rarity in recent years, especially in the US, because of an absence of active investors. But today's, retail investors have now bolstered the active ranks. So whilst Monday's activity ticked many of the boxes that we'd like to see it a market low, such as high volumes within wild market swings, there are still many other issues that remain unresolved. Retail investors are still heavily invested, but are far less active in trading. And the Fed is focused on price, not growth. And even if inflation has peaked, it will take time for it to fall back to politically comfortable levels. Therefore, the Fed will still need to hike rates, even though higher rates don't help solve inflationary bottlenecks. So what are institutional investors doing? Well, many have already rotated towards defensive sectors that offer steady growth, but supported by structural megatrends such as health care, and selected energy stocks. Some of the large cap energy names also offer dividends in the 4 to 5 percent range. Now clearly, that doesn't offset the potential losses of a major drawdown, but over an extended period, any income that's remotely close to inflation levels, becomes increasingly attractive. These stocks also provide a hedge against higher energy prices and the pitfalls of energy transition. But in order for the market to discount the risks of a retest of the lows, the Nasdaq needs to rally back and beyond the 62 percent retracement level of the sell-off, which is back up at fifteen thousand five hundred. However, the activity of the last couple of days, including the late selling on Tuesday, suggests that the nature of this market has changed and that the Fed is not going to be as easily swayed by poor price action today, compared to the previous few years. And if you have any questions about this episode, the economy or financial markets, please put them in the comments section or send them to tbc@refinitiv.com
