Market Report / May 30 2022
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.
Market Internals - Volume Tab
Low liquidity conditions argue for a trend reversal, as buyers no longer meet sellers at prevailing prices. Thus, a rally was expected, on any bit of news.
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.
CNN’s Fear and Greed Index has shown Extreme Fear since Apr 26
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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.
Exhibit 1
BofA US High Yield Index Option Adjusted Spread
Exhibit 2
UUP has resolved it overbought condition and reversed back to the 50ma. A softer dollar has historically been a bullish signal for the equities market. We have plotted a comparison between the dollar (UUP - white) vs a basket of equities, commodities, gold and treasuries (orange) as they show an inverse correlation at extremes. We would argue a softer dollar benefits everything at this juncture.
Exhibit 3
The bond market is also confirming the rally in equities. HYG (high yield bonds index - white) which is often seen as the equivalent of equities for the bonds market, rallied significantly together with equities at a magnitude not often seen even during March rally.
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.
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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