Market Report / June 06 2022
This article is written by our research collaborator, Mr. Andrei Nita, CFA L2, on the subject of current market developments.
Jobs Report puts rally on pause
It has been a volatile week with market not doing very much on the weekly time frame. SPX has registered a -1.23% performance as of Friday’s close. The market tried to rally to 4200, reaching a top of 4178 where it stalled and then got an aggressive selloff towards 4100. I outline these levels because it is important to understand why we had such price action and why we constantly monitor the options market.
As you can see below, we have the SPY gamma levels for June expiration. To the upside, there is a huge resistance sitting at 420 on SPY, while to the downside there are several support levels, most notably 410. At the end of this week, investors will receive CPI numbers, and we’ll also have OPEX day for VIX and SPX/SPY options. Why is this important? Because we might see some incredible volatility in the market.
Before I turn to discussing a few macro aspects, let’s discuss some levels implied by the options market. On the downside, the market is well hedged and I would even say excessively so, from the VIX perspective. We have strong support at 4100 and 4000 SPX. This is the reason why during Friday’s selloff, VIX had barely increased (VIX +1.41% on SPX -1.63%). Shall the market stay elevated in this range around 4100, investors who are long all those puts will not have gotten their expected move. Consequently, it is highly likely to finally get the squeeze driven by options about which we have been talking for some time. More so, shall the market go past 4200, dealers will have to start aggressively hedging their short calls positions by buying the underlying. While I do not necessarily expect to get such a rally before CPI numbers, it is worth keeping in mind this scenario.
I have been recently reading that retail investors were behind the rally we got over the past 2 weeks. Let me clarify something supporting with data: neutral sentiment and bearish positioning are still prevailing. Below you can see that retail investors were the net sellers during May’s rally:
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This data point further strengthens our belief that this rally still has no conviction in the eyes of most market participants, and it confirms what we thought ever since the early days of this leg up: “investors will short too early”.
Sentiment index is now at neutral level, but far greedy. In other words, there is still more fuel left from this perspective to support some further positive price action.
CNN Fear & Greed Index
From the volatility perspective, having VIX in the mid 20s means that the volatility target funds have to allocate more cash and increase their long exposure as VIX keeps going down. The Implied Vols are still well below Realized Vol, therefore we see significant Vol Discounts across the board. However, we do not put much importance on this measure now because we do not find it relevant in this context. Realized Vol is a reflection of past performance (and we had extreme volatility signs over the last 30 days), while from the VIX perspective we have had an extremely well hedged market (hence no reason to rush buying puts in a very short time period). Even during the past week, the majority of options bought were puts, and only very small blocks of calls were bought.
Turning to CPI, while I do not have any expectations for a lower than expected CPI print, I do foresee a possibility to have one. Some of the arguments are related to the new car sales plunge, lower mortgage applications (which are representative for the Real Estate market) and lower fertilizers prices. Additionally, Chinese ports are now working back at full capacity and we also saw a decrease in Microchips demand (I interpret this as a lower demand for tech products, not only for cars, which have such components). However, Oil is not backing off, WTI sits at $119 although OPEC agreed with a 50% increase in output.
The Non-Farm payrolls, which came in a better than expected number, was interpreted by the market as a green light for the FED to keep hiking raise in the most hawkish way possible. However, under the hood things are not so bright. I want to highlight 2 data points:
1) US labour force participation has increased significantly (a sign that wage inflation will slow down);
2) Manufacturing payrolls got a big hit (18k vs 61k est). While the Unemployment rate came at a higher than expected rate, it is still historically extremely low. While we do get news from big companies that they are starting mass layoffs, UR needs to increase significantly (probably above 5%) to force the FED to back off.
Another relevant aspect is regarding the Chinese equity markets. CCP has started to provide financial support and be more accommodative to stimulate their economy. Biden has also repeatedly talked lowering tariffs for Chinese products, and we believe that the effects of Chinese stimulus will spill over to the world’s economy and not just to China. Personally, I believe this is the time to start looking back at investing in Chinese companies, as regulations also seem to start easing, and over the next 12M the odds are for Chinese stocks market to outperform the US stocks market.
Looking at US 5Y CDS, as opposed to the March rally period, this time it has stayed elevated and has barely decreased. In other words, the credit market is still under high stress and is not necessarily supportive of this rally.
United States Sovereign CDS reached a maximum value of 24.20, and minimum yield of 8.20
On the other hand, the Option-Adjusted Spread index, does give us some confirmation and support for this rally, although it is still at elevated levels.
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CONCLUSION
Keep in mind that we are approaching quarter end rebalancing, with funds having record amounts of cash and very light market exposure. Hence, some more demand for both equities and bonds might arrive.
While the credit market is not supportive of this rally, there are several factors which support a further move up into the 4300-4400 SPX region. From our allocations perspective, we keep are long exposure unchanged targeting a higher level for the market, but we do not believe this is the time to add more long exposure if you haven’t done so already.
Andrei Nita, CFA L2