July 2023 Update

It’s not 2008 and you are not in the Big Short part II

Since our last post, despite the bearish macro backdrop, the market is up 15%, erasing losses since the Russian invasion in Feb2022 while interest rates hiked at historic pace from 0.25% to 5.25%. We stated very clearly to be wary of getting overly bearish despite Credit Suisse and Regional Bank failures. We’ve also recommended to play countertrend rallies and taking shots at opportunistic windows of non-strength. So why is market bullish?

Inflation is ‘transitory’ again

CPI prints peaked in late 2022 as we correctly called and are now cyclically trending down, stabilizing around the 5% mark. But if we look at core CPI, it’s been stable at 5% YoY since the start of year. Refer to previous posts where we dug deeper into the structural reasons why we believe inflation will stay elevated this decade.

With interest rates at 5.25% and no cut in sight, one product has seen massive inflows: structured products yielding 9-10% annually. The customer yields 5.25% holding treasuries and vol selling generates another 4-5% (selling SPX up and down 20% options).

Not only is inflation dead, volatility is also dead

Realized volatility prints 9.5%, soon to hit 2017 levels which were 30% lower than the lowest in 125 years of markets. To understand why this is happening, we have to start in late 2021. In late 2021, everybody was leveraged long equities and dancing in liquidity. But a few high CPI prints got us thinking that inflation may not be transitory. So everybody bought puts against their leveraged long positions (worked very well if you had them in March 2020). Soon after, inflation became the zeitgeist and the trade got overcrowded. As we discussed in previous posts, many long volatility funds closed shop in 2022 because buying implied volatility did not work at all in 2022. Yes, if you bought puts in 2022, you lost money because the puts couldn’t make up for the losses in your leveraged long positions.

But what has worked was realized volatility. By May 2022, as we noted in a previous post, people started deleveraging (selling stock) and buying 0dtes to not be left out of the market. If there is a vehicle to trade realized volatility, it is with 0 day options. The options expire at EOD capturing every move during the day, before the next day mean reverts itself, eroding all gains from a long put.

About 6months ago, buying 0dtes became too crowded (accounts for 40% of total volume traded) and now that also stopped working. The trade became to sell 0dtes, compressing realized volatility.

The compression is further exacerbated by the popularity structured products, which in essence, got customers selling SPX volatility, while the street is oversupplied with that volatility, creating pinning at the index level.

7 names account for 90% of the gains in the S&P500

While the index is pinned, NVDA is up 200% YTD. NVDA has seen a lot of call speculation. By no arbitrage constraints, if the index is pinned and something happens, all the pressure goes to the places where volatility is undersupplied: places where people are long options. This time, it is all the AI names: AAPL, MSFT, NVDA, etc.

Things end when positioning itself is squeezed out while macro reality still remain

Amidst this process of short squeezing, we’ve only seen a 2.5% pullback in June, and a one day sell off in July. This signifies to us that investor sentiment hasn’t gotten unbalanced to one side. We see no bear stuff but we see the Dutch boy with his thumb in the dike: as markets rise the potential energy increases behind him. Positioning is getting worse (more bullish) while liquidity is draining. The little Dutch boy is vol supply.

In 1999, the market went up 100% before crashing 90% counted from the highs. If you got in short in 1999, you would have lost all your money before the selloff came.

Outlook for August and September

Having survived the window of non-strength last week, we’re now looking at 3 weeks of structurally bullish flow. That being said, we have to be cautious in the fall. We’re likely to see significant weakness in tech before the move in the rest of the market.

Only if market goes up with vol up for some extended period of time, as market squeeze, as sentiment gets more and more bullish, will it be time to take that fat pitch and try to hit it out of the park.

Vol Trade: Long long dated calls Short stock, delta neutral

Capture the squeeze up with calls and then capture the selloff with the short stock.