- A legion of investors accustomed to uninterrupted gains just witnessed one of the worst weeks for US equities since World War II.
- In terms of rapidity, the selloff was unprecedented.
- COVID-19 was the proximate cause, but one accelerant was systematic flows.
- Here is a Heisenberg postmortem.
I suppose this goes without saying, but there's still a palpable sense of incredulity among many market participants about what, exactly, happened last week.
A long time ago (in a galaxy far, far away), I mentioned that despite readers' insistence on branding me with this or that "bear" label, history will show that, when push comes to shove, I will in fact be one of the few people not panicking when things get dicey.
It's true that I have some rudimentary Photoshop skills which I employ in the service of creating compelling banner images for some of my various musings elsewhere, and it's also true that, during times like these, one cannot reasonably be expected to avoid indulging in some hyperbole when it comes to choosing titles for posts.
But, flashy visuals and headlines aside, anyone who has followed the substance of the dozens upon dozens of missives I penned during this week's high drama will tell you that my analysis has been the very definition of trenchant.
I would argue that, when things are happening that the general investing public does not fully understand, there is no better cure for panic than trenchant analysis. People fear what they don't understand. My work this week helped folks understand how it is that US equities managed to fall from record highs into correction territory in the space of just six days.
Obviously, the proximate cause of the consternation is the coronavirus, and the headlines in that regard got materially worse on Friday evening and Saturday morning. The US, for example, reported its first death from the virus in Washington State.
You can peruse your favorite mainstream media outlet for the latest, but here's a visual (log scale) which was current through noon Saturday, to the best of my data collection abilities:
To be clear, there's no way to know how bad or swift the selloff in risk assets would have been were it not for modern market structure, and I would never purport to know whether or not stocks would have fallen more, less or the same amount this week in response to the burgeoning pandemic under different market circumstances.
What I would assert, though, is that dynamics still underappreciated by the vast majority of the investing public contributed to the rapidity and generalized ferocity of the decline in stocks and attendant spike in volatility.
Consider that out of the 25 fastest-occurring corrections (i.e., from market peak to a 10% drawdown) over the last 75 years, four of them have happened since August of 2015. This one took just six days.
On Monday, following the first of what would turn into several harrowing selloffs this week, I cautioned in a post for this platform that following options expiry, stocks were effectively "unshackled."
"Into options expiries for both US equities and USTs/rates late last week, [dealers were] extraordinarily long gamma in each of these 'ultimate' asset-classes," Nomura's Charlie McElligott wrote, recapping on Friday.
"Were," past tense.
He went on to remind folks that thanks to benign financial conditions, an asymmetric Fed policy (i.e., the bar for more cuts is much lower than the bar for hikes) and a "relatively 'Goldilocks'" backdrop for the US economy, vol.-selling behavior was incentivized as investors looked for yield enhancement and income generation. That, in turn, helped push the S&P and Nasdaq to record highs just last week.
Now, let me bring in a longer quote from SocGen which puts this in the context of what we've seen over the last several months. To wit, from a January note:
As large and positive aggregate gamma impacts the realized volatility directly (dealer need to buy when the spot falls and sell when the spot rises, thereby dampening the potential spot moves on either side), persistence of long gamma positioning can lead to low volatility over extended periods of time. As per our estimates, aggregate gamma on the S&P 500 was positive for more than three-fourths of 2019, and hence we believe this to be a significant cause of lower than expected volatility last year. Heavy gamma positioning was also among the main reasons why the S&P 500 escaped any drawdowns amidst all the US-Iran news flow in the first week of 2020.
On the bank’s estimates, January found the market in the longest stretch of persistently positive gamma on listed options since the third quarter of 2018.
(SocGen, through early January)
Well, following expiry, that "pin" (as I habitually refer to the vol.-dampening effect of dealers' long gamma profile) lost quite a bit of its influence. As I put it on Wednesday afternoon in another post for this platform, option hedging was no longer likely to keep things "calm" starting this week.
Consider this additional passage from McElligott's selloff postmortem (as it appeared in a Friday note):
Following the large expiries late last week (VIX last Wednesday, everything else last Friday), two macro shock catalysts created a profoundly negative price impulse which sent spot levels in equities index, equities vol. and rates deeply through prior ranges, which drove dealers into short gamma territory, meaning that instead of insulating market moves as they had been previously, dealer hedging flows would see them pressing into the directional moves [which in this case] meant shorting into the new lows in equities, buying VIX and buying USTs/STIRs the more they rallied.
In essence, the moves you saw in stocks, bonds and at the very short-end in rates this week, were being exacerbated by hedging flows.
The following visual gives you some perspective and historical context for the spike in the VIX and the scope of the decline in long-end yields.
On Wednesday, I mentioned that on JPMorgan's estimates, there was around $150 billion in systematic selling pressure on Monday and Tuesday alone.
According to Marko Kolanovic, the breakdown for those two days was $40-50 billion of outflows from option hedging (gamma), ~$40-60 billion of selling from CTAs, and another ~$40-60 billion of selling from volatility targeting strategies. Here is a visual on that:
As trailing realized vol. was pulled higher, the vol.-targeting universe continued to deleverage. On Thursday alone, Nomura’s vol.-targeting model implied an additional $22.6 billion of selling pressure.
Once you factor in Friday, the total for the week (in terms of deleveraging from the vol.-targeting crowd) was likely at least $90 billion. And, for what it's worth, I ran that estimate by two quants on Friday, both of whom said it was a reasonable figure.
As for CTAs, it is always impossible to say, with certainty, how much selling pressure there was, but given the relentless decline which saw key level after key level breached, you can safely assume there was "more where that came from" (so to speak) after Monday-Tuesday's $40-$60 billion worth of selling.
"The problem is, the more something 'trends,' the more leverage you need to apply to maintain target exposures, which is the working definition of 'stability breeding instability'," McElligott wrote Friday, before driving the point home as follows:
So on that macro catalyst 'shock down' which forced dealers into short gamma territory then exacerbating the moves further at the extremes (selling lows in equities to remain hedged, or buying vol/USTs/ED$ at highs), we then exposed the mechanical deleveraging flows of the systematic vol.-control/target volatility universe which now need to gross-down because VOLATILITY IS THE EXPOSURE 'TOGGLE'.
That is a point I make almost every, single day.
Volatility is the toggle switch on which all of this turns. On the market-making side, many business models were "calibrated during the years of low volatility" (to quote Kolanovic's 2018 "Risks of Market 'Uberization'" note). Volatility is inversely correlated with market depth. The thinner the market, the more price impact a given sell flow will have. The larger the swings, the more likely it is that key levels associated with CTA trend models will be breached, leading to more mechanical selling.
That's the setup. Sometimes, the entire edifice simply implodes. That's what happened this week. These implosions will become larger and more frequent over time, in my opinion. That doesn't mean stocks won't, on the whole, trend higher over long periods as they have historically. It simply means that the underlying structure lends itself increasingly to outright collapses. The optimists among you will call them "buying opportunities." And, crucially, there's nothing wrong with that!
Coming back to the point I made here at the outset, I try to explain these things to readers ahead of time and then again after the fact, in a way that emphasizes how the very same market dynamics which have brought us prolonged (indeed, unprecedented) stretches of non-existent cross-asset volatility, also make things extremely fragile.
It's never an attempt to predict an imminent crash, it's just an effort to make the general investing public aware of why, on occasion, things seem to escalate so quickly. This week saw, for example, the largest one-day VIX move (on a net basis) since February of 2018 (when the VIX ETNs blew up). In STIRs, market pricing for Fed cuts went crazy - for lack of a better word. The collapse in the Nasdaq 100's 14-day RSI was simply unprecedented (even taking into account the bursting of the tech bubble).
Retail investors often dismiss these kinds of discussions as arcana - the sole purview of people like me, who want to "prove how smart they are." Those critics of mine are wrong.
I don't care how committed you are to brushing off declines or how convinced you are that none of the dynamics discussed above matter for everyday people - this week gave you pause, even if you won't admit it. This was among the five worst weeks for US equities since World War II.
As for what comes next, markets expect an emergency Fed response. Jerome Powell released a terse statement on Friday, but traders are going to force his hand. There is no longer any question in the market's mind about whether the Fed will cut in March. The question is whether they'll cut before the meeting, and by how much. The market is effectively split on 25bp or 50bp in March (see top pane below).
After the Friday night (or Saturday morning, depending on where you happen to be based) release of PMI numbers out of China (both the manufacturing and non-manufacturing gauges plunged), you're likely to see a 50bps cut for March get fully priced on Monday.
In terms of what to expect from markets this week, good luck gaming it out ahead of time. Super Tuesday is on deck, traders expect an emergency response from central banks, a bevy of key data is due in the US and, as noted above, the COVID-19 news got materially worse on Saturday (who knows what Sunday will bring).
All of that against a backdrop where some traders are pressing shorts, exposing themselves to a violent move higher in the event the Fed steps in with something dramatic, especially considering downside hedges in equities are almost sure to be monetized if for no other reason than to cover losses on the long side.
As I put it on Friday afternoon, "all bets are off."
I'm going to leave it there on the selloff postmortem, but below is a kind of "bonus" section on ETF flows for last week, which I think some readers will enjoy as an addendum.
On Friday, Bloomberg's Eric Balchunas marveled that "history was made today as SPY became the first security to ever trade over $100 billion in a day."
Balchunas went on to call that "an absurd amount of activity that speaks to the deep level of fear in the market and gravity of [the] situation."
With apologies to Eric, I would gently suggest that it's at least possible that panic-selling by retail investors in these vehicles can exacerbate the situation when things get particularly dicey. He would disagree and, indeed, he did, although not directly in response to anything I said. Here's what he tweeted on Saturday:
To sum up: ETFs saw a record $1.2T-ish in volume last week, yet only 2% of that (-$24 billion) in net outflows. And those outflows represented less than 1% of the -$4 trillion in lost stock market value. Which means traders leaned on them for liquidity while retail hung tough, selling came from elsewhere.
There's no question about the "selling came from elsewhere" part, but this yet again raises familiar questions, not least of which is this: Aren't index funds supposed to be vehicles that encourage and facilitate low-cost, long-term investments? Is so, then is it really a good thing that something like SPY is being used as an emergency liquidity valve during weeks like this week? If flows into and out of these vehicles are exacerbating swings (and I'm not necessarily saying that they are), then who cares whether "retail hung tough"? If I create a product and the target consumer uses it appropriately, but another group of people abuses it, is it not reasonable to at least ask whether the benefits outweigh the risks?
That strikes at the heart of my ETF musings. My bone of contention with proponents of ETFs (and passive investing more generally) isn't with their self-evident assertion that low-cost, passive investing is a good thing. That issue was settled long ago by a guy named Jack Bogle (maybe you've heard of him).
Rather, my main question is this: Why can we not even have a discussion about any possible deleterious side effects? And then: Why is anyone who dares to suggest we may have reached the point of diminishing returns for the active-to-passive revolution automatically persona non grata?
In any case, that's a tangential point and a discussion that is far beyond the scope of this post, but I did want to mention it, if for no other reason than to point out the sheer magnitude of the volumes during the selloff.
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