Roger [00:00:00] The S&P500 managed eight consecutive new all-time highs until Monday, November the 8th, prompting many to think that a year-end melt-up is already underway. The last couple of months of every year, however, are always a tricky period because seasonal rallies can be punctuated by sharp pullbacks. So what should investors be looking for this time and what are the ways that people are playing it? That's the Big Conversation.
Roger [00:00:27] Many risk assets have been on a tear. The S&P500 has had a virtually uninterrupted rally since the five percent pullback into the end of the third quarter. In fact, October was also the first month since before May in which we didn't get the usual expiry led pullback, even for a few trading days. Retail activity, especially in the options market, will play a key role in the performance of the US equity market into the year end. The major option expiries will also give us a few staging posts on the way around which we should expect market gyrations to pick up in both directions. The reason why retail is key is that they have become a major player over the last couple of years, especially since the onset of the pandemic. Now, prior to that, the bid in the equity market was primarily the result of dispassionate buying from pension funds and the corporate buyback bid. These were stable and constant, and their weightings into equities was often defined by technical measures such as volatility. As long as volatility remains stable, these flows will remain positive. And that's one of the key reasons why central banks are keen to keep a lid on volatility across all asset classes. Now last year that changed when retail investors returned to the market with a vengeance. Although the retail interest started to pick up prior to the pandemic, with long positions in Tesla being expressed through out-of-the-money call options from late 2019 right into the beginning of 2020. But once the pandemic hit and the market started to rally again, options volumes were accelerated by large volumes of small-scale retail interest. Recent volumes have almost returned to the peak of the GameStop craze from the early part of 2021, and we can see with this increase in volumes, there's been a huge surge in call buying, nearly doubling from the average levels of the previous years. The favourite types of trades for the retail community have been short dated call options often bought two to three weeks before they're about to expire, and usually quite a long way out of the money, so that more positions can be bought for the same outlay of premium. And this has been a key factor all year. Favourite stocks have been tech giants like Apple and Amazon and Tesla, along with the various meme stocks that have been floating in and out of vogue all year. The surge in retail activity becomes even clearer when we look at household margin debt levels held at brokerages. From 2015 to 2020 this hardly went anywhere, but it skyrocketed over the last year, playing catch up with a market that had previously left retail investors behind. There's also been a surge in put activity too, though the increase in open interest has fallen well short of the surge in call buying activity. Now, given this interest in calls vs. puts, it may be a surprise that it's the volatility on puts that's risen the most over the last two years. As we've seen on numerous occasions before, Skew, which is the difference between the volatility and a low strike vs. the volatility in the equivalent high strike - for instance, 95 percent vs. 105 percent well, that it touched an all time high. And although this measure has receded, it still remains elevated on a long-term view. The primary driver of this has been aggressive buying of the out of the money puts pushing up volatility of those lowest strikes, whilst the retail buying of calls has often been met by selling from institutional money managers, taking advantage of those high volatility levels to overwrite positions and generate income. Although as we saw earlier this year being short those strikes, that can be fatal. But this framework sets up a potentially powerful but also very fragile outlook for the remainder of the year. Call buying is still the favoured mode of operation by the retail crowd, but there are also signs that retail are trying to get more bang for their buck by selling puts in order to generate income, to buy more calls and build up additional leverage. Another feature, which reflects both the potential power and the fragility of the market, is that both volatility and the S&P have recently been rising together, and that's actually quite rare. Normally, when the S&P grinds higher, the VIX tends to drift lower. As you can see here, it's generally a mirror image. The current move higher in the VIX doesn't look that impressive, but given the sustained rally in the S&P500, many would have expected the VIX to have fallen through the lows of the year. Periods when volatility and the market have risen together include the dotcom era and more recently, the weeks before the 'Volmaggedon' event of 2018, when many volatility products imploded and briefly caused the market to wobble. You can see that 2018 was much more derivatives and volatility event than a pure market event. When we look at the Volatility of Volatility Index, which made a new high at the time, well above the levels experienced during the great financial crash of 2008 and only bettered by the pandemic shock and passive unwind of March 2020. The point here is that rising volatility and the rising market often come with higher risks of sharp technical drawdowns. Going into the end of 2021, when we could easily get some gamma squeezes in the market. And these have been frequent events throughout the last 18 months. It's where investors buy out of the money, calls in very, very large size. But because they're so far out of the money, the actual hedge that's needed by the market makers isn't actually that much. It might be something like five shares versus every 100 shares in the options contract. Now, if the market rallies towards this concentration of open options positions, especially if the stock price is approaching them as the expiry of the options draws near, then market maker needs to buy more and more shares at an increasingly faster pace in order to remain market neutral. And this activity can accelerate the price of a share into and through those strikes. If there are options on enough individual shares that represent a big enough part of the market, then this can also have a significant impact on the index as well. Today, the likes of Google, Microsoft, Amazon, Apple and Tesla well they account for a larger part of major indices than ever before. Therefore, options activity in these shares can have an impact on the broader market. But one of the problems with analysing these positions is that options don't define the direction of the market, but they can accentuate it and in both directions. As the expiry and the strike approaches, the market can start to oscillate aggressively around those key strikes. Between now and the end of the year, there are two major monthly expiries. These take place on the third Friday of each month. We've got November the 19th and December the 17th, though the main one of these is the quarterly expiry in December. This, along with March, June and September, are usually the highest volume options expiries every year, and tend to be the focus for institutional investors. There are other weekly expiries favoured by retail investors, but the third Friday still reigns supreme, as we saw in that earlier chart showing how the major U.S. equity indices had wobbled into many of these events since May of this year. Now, the December expiry is particularly significant because after the third Friday of that month, market volumes generally tail off into the rest of the year. The main exception to that rule was a sell off into the end of 2018, after the Fed misstep of raising interest rates into an already falling market. That saw the S&P accelerate lower again, showing the impact that the expiry can have on the size of the move. Now, we shouldn't expect the market to carve out a straight line over the coming period, even without some of the potential pitfalls that i'll mention later. Seasonality has usually been quite favourable into any year end, but there is normally a wobble toward the end of November. The risks that a pullback could turn into something more dramatic have increased because of that influx of retail investors. But why is that? Well, if this market was still dominated by corporate buybacks and pension flows, then these would largely ignore macroeconomic events as long as those events didn't cause volatility to surge and upset the rules-based models that most of them follow. These types of flows are devoid of emotion, but the same cannot be said for retail flows. Retail investors, as we've seen from many social media sites, are extremely expressive. Valuations don't cause markets to fall for an extended period, it's a sustained period of disaffection from investors that does. That may seem obvious, but back in early 2020, there was little retail participation. Therefore, once the markets have been stabilised by policymakers, the rules-based investing continued as it had before, whilst retail inflows started to accelerate. Today we have conditions in which retail investors could now offset the stable flows of buy backs and pensions. It's unlikely that they're sufficient to fully counteract them at the moment, but they are now sufficient to meaningfully impact market volatility and increase the market movements in both directions. This in turn, will feed into many of the rules-based investing mandates, which in turn will add another layer of potential volatility. Thus, volatility begets volatility. Therefore, investing in the market via call options remains a good way to mitigate risk, and these long volatility positions will benefit from a surge in volatility even if the market goes in the wrong direction. Now, call volatility has already increased, but it still remains relatively attractive versus the volatility of the underlying market, whereas put volatility is still expensive and may cost 5 to 10 points above the actual volatility of the market. Some of these puts may look attractive, and for those who understand the risks, there is some juice there. But the increased put selling to fund call buying also opens the possibility that the downswings when they come, could be more aggressive than we've been used to for most of the recovery off the 2020 lows. And furthermore, there are some macro issues that are bubbling beneath the surface. China is continuing to attempt to rebalance the economy. So far, this has been a measured move and one that's been largely ignored by the wider market, reflecting the introspective nature of China's current economic policy. But since the Evergrande headlines, however, China's property sector has remained under sustained pressure. The June 2030 bond of Country Garden Holdings has lost 10 cents in the dollar since the beginning of November. The Sino Ocean Land May 2029 bond has fallen close to 15 cents in the same period. This is a company that's perceived to be backed by regional governments. These issues in the offshore dollar bond market are repeated across a number of companies, and this has all taken place since the last-minute payment of Evergrande's dollar bond holders, which it looked like they were going to default on only a few weeks ago. China's real estate index is significantly underperforming the broad-based market as the issues spread further, and this has been reflected by another leg lower in the Asia-Pacific High Yield Bond ETF, which has fallen well below the spike lows of the pandemic bust. So far, all this appears to be contained. Global investors expect that contagion will not spread beyond China's property sector or outside of China and its territories. But there have been some very clear reversals in China's headline commodity sectors, such as iron ore and thermal coal. Iron ore has dropped by nearly 60 percent to below the pandemic levels in a sign that some of the commodity exporters to China may soon see lower prices and volumes. The Baltic Dry Freight Index, which reflects global shipping, has posted nearly two weeks of straight declines. The point is that China might not be an issue right now, but it can easily become an issue in the future, given its pivotal role in true global growth. Back in early February 2020, the pandemic was well known, but the U.S. equity market continued to make new highs into the middle of that month. The base case today is that the U.S. equity market will continue to rally into the end of the year, but investors need to be wary that the acceleration of retail investors buying the upside gamma while selling puts to finance leverage could combine with the proximity of the major expiry December to accentuate any external risks that could spread from China. Equity markets continued to rise with rising volatility into the dot com peak of 2000, but there were many extreme durations along the way. Long calls or even selling out of some stock positions to buy calls and bank some capital, are some of the ways that investors are looking to participate into the hoped-for year-end rally whilst managing their risks as this market continues to power ahead, whilst at the same time it becomes increasingly fragile. If you have any questions about this episode, the markets or the economy, please put them in the comments section or send them to TBC at Refinitiv dotcom.
