CHG Markets Round Up Issue #5: The Stories the Markets are Telling

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There is so much effort put into talking about markets, explaining why things go up and down and trying to predict what might happen next that it distracts from seeing what is really taking place. After more than twenty years doing this, I have settled on looking at market prices through the lens of the [[Auction Process]]. It is simply supply and demand. When they are balanced the market stays within a range, when they are out of balance the market trends. You see this everywhere, across markets and time frames; it is an ongoing conversation between market participants.

S&P 500

Below is a monthly chart of ES futures going back to 2016. This is a picture of a long-term upside auction. Buyers have been dominating the market since COVID with only minor pullbacks to work off short-term excess.

After COVID, the market auctioned higher until 2022 when it came into a two-year balance when inflation picked up and the Fed started raising rates. Balance can take various forms and can persist over any duration. The important message that balance communicates is that there is a rough consensus between market participants about price and value.

Here is the upside auction since the August low. Notice how prices have not needed to move significantly higher to balance supply and demand. Despite buyers continuing to dominate, prices have not needed to move higher for sellers to appear. This could be new sellers who think price is above value, or it could be short-term traders who are taking gains.

What we should be seeing in these pictures is that auctions tend to have the same characteristics regardless of the time frame; over the short- and long-term the forces of supply and demand work in the same way. There are periods where the market comes out of balance, when prices move higher or lower as prices are viewed as diverging from value. There are times when the markets remain in balance, when price and value seem to be in broad agreement. We have previously cited Charles McGarraugh’s asset duration theory which looks at the power of feedback in relation to the frequency of realization of information that we should now see at work in the preceding charts. These common characteristics can be thought of as words in a sentence that the market is writing and just like adjectives can be used to describe nouns, we can leverage the idea of asset duration to understand markets that are trending or in balance.

The S&P 500 has re-entered the prior balance range after a gap higher and upside breakout after the election. As we have seen this sort of behavior is not unusual, but it does provide useful context for the ensuing conversation. We experienced a realization of information with the election and the markets quickly moved price in expectations that will take months, if not years to be realized. The prior range high and low are now important references from which we can measure the strength of those expectations versus the uncertainty of their realization. After the initial upside move it would be natural for the market to move back to the range low and test support as this is a stabilizing action for the market, kind of like a pause in a story to establish or clarify something important. It would also be natural for buyers to surface at the range high and sustain the upside breakout and it would communicate what sort of buyers are dominating the market at the current time. Depending on what happens next, we now have some useful references to help us understand the message the market is communicating.

Now that we have a handle on the supply and demand picture, we can look at the options market to get a sense of what the betting lines are for the market. But first a chart of the SPY with 20-day and 180-day realized volatility in the lower pane.

As we can see longer-term realized volatility is stable around 15.5%, so we can use that benchmark to compare current option market pricing and see what the distribution of future outcomes the market is expecting for April 2025. The picture below shows two scatter plots of probabilities derived from butterfly option spreads. The red scatter is the flat volatility benchmark of 15.5% and the blue scatter is actual butterfly prices which reflect market expectations and include volatility skew.

Interestingly, as much hype as the Trump 2.0 rally has received in the news, the response from the options market is tepid as it expects the market to basically stay at current levels through April of next year. This pricing is a result of the decrease in implied volatility for the ATM options which gives us those blue dots well above the peak of the red distribution.

Since a probability distribution must sum to 100% for there to be no arbitrage, this increase in probability for unchanged outcomes means that the probability of other outcomes needs to decrease, and we can see that the market is now underpricing the intermediate downside and upside scenarios in the distribution. With the tails fairly priced (assuming we realize 15.5% vol between now and April) the steep peak of the distribution pulls the distribution up making it skinnier than a normal distribution that we see from the flat vol pricing (red dots). This means that straddles are inexpensive (because there is a lower probability of extreme moves). We can quickly prove this intuition out using Kris' shortcut for straddle pricing to see that ATF straddles in April are trading about 30% cheaper than our 15.5% realized vol would imply.

If we plotted vertical spread prices on a y-axis against strike prices on an x-axis we would see an S-curve and the more skew there is the S-curve flattens out because the OTM options are worth more. Since a butterfly spread is a combination of vertical spreads skew makes OTM butterflies more expensive which directly impacts the implied probability distribution we see above. In that picture we see the combination of flattish put skew and flat call skew, combined with low ATM vol which shifts the median of the distribution to the right, making the distribution thinner, OTM put spreads inexpensive because of the put skew, and OTM calls inexpensive because of the low level of implied vol and lack of call skew.

This is the second wave higher of the long-term upside auction and while there is not a set number of waves that determines age, time is constant which means that the rally is getting older, and as auctions age, they become less stable partly because they are exposed to more realization of information. The option market pricing stands in direct contrast to this, it is showing a very narrow range of expected outcomes with a bias higher. In this situation upside and downside beyond the market's narrow range of highly probable expectations would be destabilizing. The put skew in the options market causes the left side of the peak of the distribution to widen out a bit which means that pullbacks like we are seeing now can be stabilizing (when highly probably market outcomes are realized it is stabilizing). However, too much of a pullback can be destabilizing and we can see where that is from the implied distribution and the bar charts. The 5724 level is important short-term support for ES futures as both the October and November lows are within a point of each other at the 5724 level. This reference is squarely in the portion of the blue dots that are below the red dots on the left side of the distribution above which shows that the market is pricing a lower probability of that outcome relative to our flat volatility assumption of 15.5%.

The Dollar

One of the biggest movers since the election has been the dollar (DXY index pictured below). Despite the rally the dollar remains in the range it has been in since its failed upside breakout in 2022 which has been defined by the February-March 2023 two-month range. It is a significant piece of information that the market’s view of price and value has not moved beyond that narrow range for over a year. As the market approaches the top of that range the risk increases because the price is now at the upper end of the recently established value. If the market fails to breakout higher and retest the 2022 highs, the odds of testing the range low increase because we have not seen a realization of information that has changed the market’s view of value. Further, since the 2022 upside breakout failed, it has not retraced to the prior 2018 range low which means that we have two different auctions testing the upside of their ranges at the same time, which further increases uncertainty. While the initial upside impulse in 2022 failed to see a realization of information to justify expectations, it has also not realized information that strongly disproves the expectations.

This may be one of the most important charts in the markets today. The dollar initially rallied after Trump's election in 2016 but then sold off substantially into 2018 while never fully recovering during his first administration. It wasn't until the Fed raised rates at the fastest pace in history that the dollar was able to retake that high in 2022. Since then, we have been waiting for resolution of that upside breakout. How the dollar trades around this balance high will be very important for setting the context for the next chapter of the story the dollar is telling.

Gold

In March this year we saw gold breakout from a four-year balance to the upside. Since that breakout not one month saw a low below the prior month's low (one-time-framing higher) until recently. For the first time since March gold has stopped moving higher on the monthly bar chart. Like we saw in the charts of the ES and SPY, this sort of thing is quite normal for a trending market, it is a form of short-term balance where the market pauses as supply and demand have come into balance and then we wait to see how the balance is resolved. If real sellers have appeared and are now dominating the market, we will see the market turn lower and one-timeframe lower. If this pullback is just late long selling and buyers continue to dominate the market, we will eventually see the short-term balance resolved to the upside. Finally, we could also see a longer-term balance range develop like we saw in 2020. The important thing about this otherwise small development is that it is a form of change, and it has clearly come in reaction to the election and the stronger dollar. There is an interplay between these markets at play and observing each one individually will be important to understanding the story the market is telling us.

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