This article is written by our research collaborator, Mr. Andrei Nita, CFA L2, on the subject of current market developments.

Recession fears overwhelm the market

It has been a volatile week and since our previous article regarding a potential rally driven by options expiration, the market has done a lot under the surface.

Let’s start with a first! SPX just experienced 7 down consecutive weeks, something that has not happened since the 2000s dot com crash. For reference, the whole Covid crash lasted 5 weeks, while the 2018 crash lasted 12 weeks and 78% of the 2018 total drawdown happened over the last of 7 weeks. In other words, the market is grossly extended to the downside, in a short period of time, getting into 3 Standard Deviations from 200ma and 2 Standard Deviations from the 50ma.

While last week we indeed had a rally in the first part of the week reaching SPX 4090, the second half brought an aggressive market flush with recession fears overwhelming investors. Credit market has also been reflecting this financial stress, with US 5Y CDS reaching values lastly seen in Febr 2020 and Sept 2020.  The bond market looks to have started to price in a growth slowdown as well, as the 10Y yield topping (for now) at a similar level to 2018 (3.2%). What is more relevant in my opinion, is the start of a breakdown of the positive correlation between TLT and SPX. In other words, investors are starting to have a place to hide, as until now both bonds and equities got sold off all together. However, is a bit too early to allocate aggressively cash into bonds.

Turning our focus to market positioning, according to CFTC, the amount of futures short in Russel 2000 (IWM) is significantly higher than in 2018 or in 2020. Something to keep in mind. Moreover, the Money Manager’s cash position is also at an extremely high level. Why is this relevant? It tells us that now market participants are not only bearish in their view, but also in their positioning. We are now in a window when corporate buybacks have green light. With SPX reaching the -20% and Nasdaq -30% thresholds, Money Managers will soon need to start deploying back their cash. Why is that? Well, the majority of pension funds, trust funds etc need to be invested 95% the majority of the time. So some liquidity to support the market might arrive in the not too distant future courtesy of these institutions.

The options expiration squeeze we have been talking, could not lift the markets, although on Friday during the last hour you could have seen a spectacular market recovery driven by options. Unfortunately, that was an OPEX only driven market as DXY (dollar index had not moved). Once DXY starts to crack down, the chances for a more sustainable bounce would rise. With the 3900-4000 SPX May put options gone, the next levels we are interested in are 3650-3700. Why is that? Because the majority of the put options with those strikes (with June/July maturities) were purchased deep OTM, and if market manages to push SPX to 3600, the amount of hedging dealers (which are short those puts) will have to do might create a real crash (limit down day type of crash). Judging by the maturity date, most of the hedging is done for FOMC, which we will have this week. On the other hand, should the market manage to hold around the 3900-4000 level and provided Powell does not crash the market (again) during his conference, the set-up could be similar to what we had in place in March before the rally, especially with investors now expecting every rally to fade quickly.

The last point I would like to highlight is how well high beta stocks held this week (the best proxy for high beta stocks is ARKK). While the indexes were printing new lows, these extremely beaten down stocks were significantly above their lows and did not drop intra-day as much as they have done until recently. It is well known that stocks bottom well before indexes, and if that is the case it remains to be seen. For now we shall watch carefully and not make any firm conclusion yet in this regard.

Andrei Nita, CFA L2