The Heisenberg wrote:
- The Dow fell into a bear market (at least intraday) on Wednesday, another session that found the benchmark down more than a 1,000 points.
- This “yo-yo” price action is not as inexplicable as it seems, and regular readers are acutely aware of the dynamics that are exacerbating things.
- And yet, considering the circumstances (which are, in a word, extraordinary), I wanted to pen another “guide for the perplexed.”
“What the hell is goin’ on?,” my accountant half-shrieked, when I called him on Wednesday morning to make sure he’d filed my corporate return.
Norbert (not his real name, but close) is a lot like the rest of you: Flabbergasted by the sheer scope of the daily gyrations in US equities.
But, as regular readers are acutely aware, these “yo-yo” swings (as it were) are not wholly inexplicable.
Obviously, the coronavirus scare is the proximate cause of the market’s consternation, but the stage was set for this kind of wild price action once we lost the vaunted “gamma pin” after options expiry last month.
It was at that point that stocks were “unshackled.”
On February 24, I penned the following headline: “Gamma Collapse Opens Door For COVID-19 To ‘Shock-Down’ Stocks.”
Time-stamp that, folks. Time-stamp it and put it on a chart. Or, actually, don’t bother. Because I did it for you:
To hijack and adapt one of the many memorable quotes from the Coen brothers’ immortal classic The Big Lebowski: “Do you see what happens, Larry? Do you see what happens when dealers’ gamma profile flips negative?”
On the morning of February 24, I wrote that the virus outbreak and still elevated equity valuations “need to be considered against a post-Op-Ex reality that finds the ‘gamma pin’ (colloquially: the force that’s kept spot ‘sticky’ and acted to damp volatility) losing a good bit of its influence.”
That’s a point I reiterated in multiple posts for this platform, including one that day (i.e., on February 24) and another one less than 48 hours later.
There was still some skepticism among readers about the extent to which this quant-ish (if you will) arcana “matters,” but I imagine some of that skepticism has evaporated over the past week. As I wrote on March 8 in these pages, “any explanation you read purporting to explain [recent volatility] that doesn’t reference gamma squeezes, systematic flows, a lack of liquidity provision and/or a dearth of market depth, can be dismissed out of hand.”
Against that backdrop, things really didn’t need to get any more precarious for markets, but they did anyway over the weekend, when the Saudis slashed OSPs across-the-board, sparking a price war with Putin in retaliation for Moscow’s recalcitrance in Vienna last week. That facilitated the largest single-day collapse in crude since 1991.
The phrase “insult to injury” doesn’t even begin to capture it.
Coming off the weekend, we were still miles away from levels that would flip dealers’ gamma profile back positive and otherwise create a situation where systematic flows would again be supportive of markets. We had already thrown gas on the proverbial fire. The oil collapse was like tossing a grenade into a raging inferno.
“Imagine being a market maker who sold puts to major E&Ps and was already staring into the abyss after the last two weeks’ -25% move [and] now having to sell futures deep in-the-hole off the reopen gap lower last night/today,” Nomura’s Charlie McElligott wrote, on Monday morning, following a truly chaotic session in Asia.
Over the weekend, in the second linked post above, I mentioned that credit was starting to crack late last week. Just about the last thing a nervous credit market needed was a 30% collapse in crude prices.
I’ll make two quick points in that regard.
First, CDX IG spreads (think of CDX.IG as the investment grade “fear gauge”) jumped the most since Lehman on Monday. But that’s not even the most astonishing part. Rather, the really shocking statistic is that the move wider was anomalous compared to the move lower in equities which was itself the largest move since the crisis. Have a look at this scatterplot:
(Bloomberg, h/t Luke Kawa)
Second, high yield energy spreads ballooned 342bps wider on Monday. That is the largest percentage move in history. High yield CDX had a six standard deviation move that morning.
What does that mean? Well, it means that the market believes some folks are likely to run into operational difficulties going forward. And that’s me being very euphemistic.
Again, that was insult to injury or, as SocGen put it in a Wednesday note which brings it all together, “the final blow.” Consider this passage from the bank’s latest volatility update:
The sharp drop in equity prices on 24 February sent the dealer positions deep into negative gamma territory, leading to daily amplitudes not seen since 2011. After that, all the other drivers went into play and enhanced the vol pick-up: deleveraging from passive funds (risk parity and vol.- target), short covering in the VIX market and forced selling in various assets to meet mark-to-market constraints among others. The plunge in the oil price came as the final blow.
That captures everything noted above – the negative gamma dynamic, the subsequent deleveraging from vol.-targeters, the forced selling and the “death blow” on Monday with oil’s historic collapse.
The following visual from SocGen shows you the large absolute moves (i.e., higher and lower) in stocks since February 24 in the context of the gamma discussion. Note from the caption below the chart that the “Speed Index” is the spot move needed for aggregated gamma to flip from positive to negative when the Speed Index is negative (and vice versa).
Of course, once the benign dynamic wherein dealer hedging flows tamp down the selling in stocks “flips” (i.e., once dealer hedging begins to exacerbate directional moves instead of dampening them), it sets the stage for the kind of wild price action that drives up volatility, which in turn depletes market depth, in a pernicious feedback loop.
The “gamma trap” and the inverse relationship between market depth and volatility are two of the main reasons why you’ve seen such a dramatic escalation during this COVID-19/OPEC+ panic.
As alluded to in the excerpted passage from SocGen (and as I’ve detailed on countless occasions), it doesn’t stop there.
Once spot careens through key levels for CTA trend and momentum strats, they deleverage into a falling market. That “abrupt unwind propagates their own negative momentum,” to quote JPMorgan’s Nikolaos Panigirtzoglou.
Once trailing realized starts to move higher, the vol.-targeting universe deleverages “passively” (if you will), and that selling continues to execute in the market until volatility resets sustainably lower or they run out of exposure to trim. Consider, for instance, the following updated visual:
In the space of roughly a month, the target-vol. universe has pared its exposure to equities to the tune of some $130 billion. Looking back three months, it’s almost $200 billion.
Now then, if you’re wondering what’s going on during sessions like, for example, Tuesday, when stocks explode higher, you’ll note that once some catalyst (in Tuesday’s case, it was Trump promising to deliver an economic stimulus package to offset the hit to the economy from the virus containment measures) gets things moving, the same underlying market setup/dynamics work to accelerate the upside.
Consider, for example, this excerpt from the above-mentioned McElligott (from a Tuesday morning note):
Today has the feel of a standard “bear-market rally,” where selling is increasingly exhausted, monetization of dynamic hedging in futures shorts turns into a rather violent “squeeze”; as stated repeatedly, the enormous “Short Delta” via SPX / SPY options (-$560B, 0.6 %ile since ’13) will continue to act as a “core” catalyst for these raging UP trades (despite still-horrible sentiment and outlook from clients) as these options “have to” be monetized when they’re this in-the-money, especially as they’re expensive to roll.
All of the above has created a perfect storm for volatility and generally manic market action, the likes of which many current market participants have simply never witnessed before. After all, Lehman was nearly a dozen years ago, which means someone who’s, say, 25 now, was just 13 years old when I was dumping the “gin-soaked ice cubes” in Mikey and Becca’s sink.
Importantly, it’s not just young folks who are shell-shocked. There is still a generalized unwillingness among many market participants to come to terms with what the evolution of modern market structure entails during periods of panic.
And just as I wrote that last sentence, the following headline crossed on the terminal:
- DOW FALLS -20% FROM FEB. CLOSING HIGH INTO BEAR MARKET TERRITORY
I’ll just leave it there for now.