Friday morning brought some relief for U.S. equities (SPY) and it's a good thing, because Thursday morphed into yet another steep selloff in late trading, a testament to the "snowball" effect I warned about on Thursday in a post published here just before things in fact snowballed.
I wanted to pick up right where I left off in that linked piece on the way to delivering a more upbeat take which I imagine will be welcome in light of recent events.
Towards the end of my Thursday post for this platform, I said the following about what was likely to emanate from strategists following the Wednesday/Thursday slide:
You can bet that over the next couple of days there will be multiple attempts by analysts to document liquidity provision during [the] rout.
Sure enough, on Friday morning, Goldman was out with a post-mortem and the headline from their analysis is most assuredly this:
Compared with pre-event annualized realized volatility of 6.4%, Wednesday’s 3.3% SPX selloff naively represents an 8-standard deviation event, the 5th-largest tail event in the index’s 90-year history.
The "naively" qualifier is meant to convey a bit of skepticism about classifying Wednesday as a major event while still communicating an appropriate sense of alarm. The reason Wednesday sticks out is because Q3 2018 was one of the five least volatile quarters for the S&P over the past two decades.
Those interested in more on that can find it here, but for our purposes I wanted to pick up on the point made yesterday about liquidity provision and market depth. In the same Goldman piece, the bank notes that market depth was actually worse on Thursday, thanks to lower, but still high volume. To wit:
As would be expected with high volatility, SPX futures’ quoted market depth has been even lower than it was through much of this year. What was less expected is that futures’ depth worsened on Thursday: in the height of Wednesday’s price action, high volume enabled deep markets; lower volume but high volatility has left low bid/ask depth on Thursday.
As you can see from those pie charts, Wednesday doesn't look too bad, but Thursday looks absolutely awful. While I am in no position to make any kind of sweeping pronouncements about whether and to what extent modern market structure might have played a role in diminished liquidity, the bottom line is that market depth fell on Thursday, and you'd be remiss not to at least ask whether that might have played a role in turning yesterday into a mini version of Wednesday.
Here's some historical context for those visuals which includes the August 2015 rout (i.e., the yuan devaluation scare), the early 2016 global deflation panic and the February VIX quake:
Again, this is something to keep an eye on. I'm hardly the only person to suggest that modern market structure is in part responsible for market depth deteriorating and liquidity provision drying up during times of stress and I continue to believe that makes things more fragile than they were before the proliferation of systematic strats, passive vehicles, smart-beta products, etc. A lot of those strategies and products are prone to forced de-risking and indiscriminate selling/rotations when something shifts. When you throw in programmatic market making, you've got a recipe for vanishing liquidity.
Ok, so let me shift gears and throw the bulls a bone for a minute.
A reader asked me the other day if buyback blackouts might have served to leave the market "naked", so to speak. The answer to that is "probably".
Remember, the corporate bid is the largest source of demand for U.S. equities and there's plenty of evidence to support the contention that without buybacks, 2018 might have looked a lot different for U.S. stocks.
Well, as Nomura's Charlie McElligott wrote on Thursday, "the current corporate buyback blackout was always going to be the window where we had to expect the market to trade without a net —in particular, its largest sector weightings, Tech + Comm Services at ~30% of SPX which is an even-larger part of the overall notional buyback allocation."
That raises the following question: Will equities get some support once the blackout is over?
That's probably too narrow. The real question is whether the disparity between authorizations/announcements and executions will normalize and thus put a bid under stocks into year-end. Consider this from BofAML's Jill Carey Hall:
Repatriation tax law changes have led to an increase in equity buyback announcements from US corporates. However, amid elevated equity valuations (and a focus on other forms of cash deployment, such as capex), less than 50% of S&P 500 index buyback announcements in 2Q were executed, based on data from S&P and Bloomberg.
Obviously, the implication there is that the ratio shown in that chart will normalize, and if it does, that should support stocks, in particular tech (QQQ). Goldman made a similar argument back in August, for those keeping score.
But that's not the only argument for a rally into year-end.
While there are certainly no shortage of reasons to be wary of the U.S. midterms, there's a sense in which the D.C. gridlock which will almost assuredly come to pass in the event Republicans retain the Senate but lose the House, will actually be a positive development for U.S. equities.
A Republican sweep could open the door to an even more combative trade stance from the Trump administration, and while the gains from late-cycle stimulus are already in the books, the potential downside from the trade frictions has yet to be realized. So a split Congress could potentially temper the trade war, but likely won't (or "can't" depending on what policies you're talking about) roll back any of the stimulus that's helped underpin the rally.
Beyond politics, you can always lean on the old "positioning is cleaner now" argument following the Wednesday/Thursday drawdown. That's a pretty generic way to look at things and "cleaner" is a loaded term, but at some basic level, it's undoubtedly true that these episodic purges are cathartic.
In his Friday missive, the above-mentioned Charlie McElligott also notes that "negative earnings revisions into EPS season" mean the bar for beats is lower, and he goes on to highlight bullish seasonality. Here are a couple of easy-to-read visuals on that latter point:
Those are seasonals for October 12-November 12.
So, if you're in the camp that's looking to buy the proverbial dip, I've just given you four arguments that should help in your daily quest for confirmation bias:
- an elevated announced-to-executed ratio on the buyback front,
- the possibility of "bullish gridlock" (™ Heisenberg) after the midterms
- cleaner positioning after this week's rout
- good old seasonality
For the bearish contingent, just know that vanishing market depth and evaporating liquidity are facts of life in today's environment, which means that on any given day, your shorts and tail hedges have the potential to deliver a windfall thanks to turbocharged drawdowns.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.