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

Reflexive rally doesn’t convince investors

There should be no surprise for our readers that the market, from last week’s low, has rallied 7.2%. We have outlined a few important reasons why we saw high odds of a reflexive bounce here and here. Eventually we got it. Signal Sigma algs saw the opportunity, and triggered a long allocation trade signal early last week, which is already showing a nice profit.

While there was no surprise for us that we were going to see such a rally, what I do see as a surprise is the way this bounce happened. I have previously outlined that an options driven rally was most likely to happen, and although we did get a rally it was not at all driven by options as I was expecting. Rather, we saw a lack of sellers and the few buyers that were in the market had to chase prices higher in a low liquidity environment. 

The apparent catalyst was the FOMC release, where we felt a less hawkish tone from the FED. While the broad market started going up, the options market was experiencing neutral to bearish activity. Participants mostly kept buying puts with June expiry and sold calls, concurrently. In other words, the bet was on a quick rally fade followed by a continuation of the selloff, as scenario we have been continuously experiencing since March. This negative sentiment  still present is also confirmed by the Fear and Greed index which is showing “extreme fear” readings despite the market rally.

My initial expectation was that we would top around 4200 SPX (futures are already at this level at the time writing). However, considering the amount of bearishness still present and the large amount of puts purchased, I believe market might surprise us with a much higher than expected top for this rally.

Andrei Sota, my colleague and founder of Signal Sigma, outlined the max pain theory path which the market might follow: “Rally fades. Bears will short. They are too early. Then another leg higher, until most bears give up. Then, bulls that were on the sideline will deploy cash. They are too late. We tank hard again to SPY 350-360. Bears lose. Bulls lose.” As evil as this sounds, it might indeed be the case we will see into summer. Volumes were low on these up days and most probably because of the lack of trust in this rally, confirming that many participants are still on the sidelines and that there was no real engagement yet from the majority. A peak will not be reached until the sentiment changes more toward positive and more investors get back on the long side. Also, we need to see higher transaction volumes that would confirm a “panic buy” moment.

My long term view has not changed, and until I see a clear dovish pivot or the market fully price in a recession on the indexes level, I believe we are still in a bearish macro environment. However, shorter term we did get some positive signals. First of all the credit market is giving us signs that this market might indeed be sustainable for now. OAS have decreased steeply, a move similar to what we saw back at the end of February when the March rally has started.

Another interesting aspect which caught our attention is the decrease in rate hikes expectations. For July, a 50bps hike chance has decreased while for Sept there are some suggestions of a pause. Even more striking, for 2023, we start to see some pricing of a rate cut. Remember, the market is always forward looking in terms of expectations. These changes came as a result of both the FOMC and the PCE numbers we got last week.

Going forward, I expect two major catalysts which should make shorts very cautious. Firstly the huge OI in puts, which up to this point has not seen any weakening and secondly, the quarterly rebalancing period into the end of June which shall bring some more buying pressure with funds being hugely underweight equities.

Conclusion

We will soon start considering a reduction in our risk exposure. We will start by trimming the most speculative positions first, then be very patient with initiating new shorts as this rally might still be in its early days. Time will tell, but we are monitoring developments closely and will keep you updated with our thinking.

Andrei Nita, CFA L2