Tail Whisk

“Just for once, could you not look at the bright side?”?

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Negative scenarios have a peculiar way of sneaking up on us.

Key takeaways:

o??The most important statement to remember during the upcoming six months of debt ceiling drama is from Treasury Secretary Yellen. She is “confident [that] extraordinary measures can last to early June.” The Treasury will add liquidity to the market, a positive that dominates default concerns for now. However, once debt ceiling issues are resolved, those flows will be withdrawn. If accompanied by spending cuts, markets will not react well to the prospects for drastically lowered liquidity.?

o??June 15-16 is the date of the second BOJ meeting headed by Governor Kuroda’s successor. The question is, will yield curve control policies be changed at the late April meeting, immediately after Kuroda steps down on April 8? If changes are made in June, investors will be marking the month in their calendars as an explosive time for the US and Japan.

o??There are 27 states exhibiting negative growth as of Q4 2022, versus a median of 28 at the beginning of all recessions since 1980.

o??Federal Reserve Governor Waller has confirmed that the Fed and the markets are not aligned: it is “hard to talk markets out of their forecast,” he said, and “if loosening financial conditions means inflation takes off again [it] will require us to do a lot more.”

o??Moody’s has issued a warning about rising default rates in commercial real estate firms. They highlight a concern about a double whammy of inflation eroding profits and high borrowing costs creating problems funding their operations.

Margins at the margin Dept: Since higher inflation increases operating leverage, as inflation expectations fluctuate, margins become more volatile. While investors have been bidding up stock prices as inflation expectations fall, unless the economy recovers quickly, negative operating leverage will dominate price action, not the current “market…optimism inflation will melt away” that Fed Governor Waller describes.

In fact, the drop in margins and earnings will be the cause of the eventual rate pause and easing cycle due to the resulting rise in unemployment. To repeat from last week, the NFIB small business survey noted that hiring plans have fallen to a two-year low. Please note that small business drives overall employment. Small firms are going to feel the effects of the 2022 policy-tightening pipeline fully in 2023. By that time, the stock market will start to offer value, but from a much lower level.

Our main concern is that the economy will be vulnerable to left-tail risks as investors trade in a stock market subject to quick swings due to option positions with “zero days to expiration.”

As mentioned in the Moody’s report above, there are concerns regarding high borrowing rates creating a severe overhang for distressed firms, particularly in commercial real estate. The prospect of firms having to roll over debt at much higher rates is reminiscent of the housing crisis that was inflamed as many homeowners had to refinance their maturing variable rate mortgages at higher short-term rates.

From the consumer side, personal savings rates rank among the lowest of the past century, and the following two charts on negative real wages and auto delinquencies are not a coincidence:

As the average car payment hits $10,000 annually, US auto loan delinquencies reach 2007-08 levels:

“Give me liberty or give me zero days to expiration”

If we pair the potential economic air pockets above with the recent popularity among dealers to sell options that expire the same day (hence the name zero days until expiration or 0DTE), there is cause for concern. If an institution sells an option on the day of expiration, there is no need to post collateral and they sell far out-of-the-money options to collect a premium. The dealers look at the transaction as a costless, risk-free trade—until it is not. A market moving event that creates a large selloff would be amplified by the existence of these short option positions making 0DTE this decade’s version of portfolio insurance. At a smaller scale, it can accentuate quick one day moves in the market, as we witnessed on Friday’s option expiration. These moves can happen in either direction, but on the downside, individual equities become highly correlated, along with all asset classes, which make for much sharper and sustained downturns.

This is a formula for a major move down as an unexpected event hits dealers with big negative gamma option positions and generates intense selling that spills over to institutional clients who need to reduce positions as their risk management models trigger forced selling.

We are left with a precarious recipe of volatile option books, an increasingly fragile business environment without a low interest rate safety net, and a consumer with diminished real income. Add a dash of high operating margin volatility, include a side of restrictive monetary policy lags, and we are ready to serve.

Importantly, this type of event is not something to position for, but it is beneficial to know it exists. As mentioned last week, “For now, momentum is higher in both asset classes.” Nonetheless, we are watching for tremors.

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Regarding the markets, last week’s note warned that “any intraday move this week below 3950, and certainly below 3930, should trigger stops and generate heavy selling IF the market is topping.” The S&P 500 closed at 3929 on Wednesday, but only had a small range with low volume on Thursday despite spending the entire trading day below that critical 3930. Typically, a break of support ushers in a large move to the downside as longer-term players liquidate longs and others open short positions. Thursday’s low prices did not attract new supply from those longer-term players.

At what point should a selloff bring in longer-term sellers? Early this week, a window opens below 3920, but the real risk lies in a break below 3860 in the cash index. More selling should come in below the 3800 level. On the upside, 4030-4080 could see demand evaporate, at least in the intermediate term.

As bullish sentiment extends, I am monitoring the percent of NASDAQ stocks above their 50-day moving average because it sits at an overly bullish reading of 60%. It reached 75% at the August 4325 S&P 500 highs before dropping below 10% in October. If the reading remains in this recently overbought area and moves higher, that will resemble a bull market. That is not expected, but it merits watching.

Peter Corey

PavePro Team

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