Macro and Flows Update: May 2023 - e17
Summary
TLDRThe video discusses the market trend known as 'sell in May and go away,' highlighting its historical basis in the context of quarterly expirations and market risks. It emphasizes the current heightened risk due to 18 months of interest rate hikes, inflation concerns, and the potential for a market squeeze. The speaker advises on strategic investment approaches, such as delta-neutral trading and hedging, while cautioning against potential stagflation and market vulnerability. The video concludes with a warning about the risks of an illiquid market and broad market tops, urging viewers to exercise caution.
Takeaways
- 📅 The 'sell in May and go away' mantra is based on historical market trends and potential risks associated with the quarterly expirations, particularly in non-holiday months like March, June, and September.
- 🔄 The market experiences a shift in risk around option expirations due to open interest and embedded tail risk, which can lead to significant market moves, as observed in the past during similar periods.
- 🌱 After a strong spring market cycle, there is a seasonal tendency for the market to enter a period of weakness, especially post-March Opex, which can continue into the summer.
- 💹 The current market rally is different from past patterns as it hasn't been preceded by a significant February decline, calling for caution in the market.
- 💰 The market is now approximately 18 months into the raising of interest rates, which can have a lagging effect on various economic activities and markets.
- 💽 The rapid quantitative tightening (QT) and the Treasury General Account's actions can lead to a sudden liquidity shift, impacting the financial markets.
- 📈 Inflation has remained stubbornly high, and the market is not responding to the Federal Reserve's policies, leading to a more hawkish stance by the central bank.
- 🔄 The risk of a short squeeze exists when markets rally, as short positions need to be covered, leading to potential overvaluation and market inefficiencies.
- 💡 Options trading strategies, such as buying calls and hedging with stock, can provide exposure to upside potential while also protecting against downside risks.
- 📊 The market is becoming increasingly vulnerable to shifts in implied volatility, which can lead to significant moves and potential market adjustments.
- 🌐 The real risk for markets may not be a deep recession but a stagnation scenario with high interest rates, earnings compression, and persistent inflation, leading to stagflation.
Q & A
What is the significance of May in the context of the stock market?
-May is significant because it is a serial month that precedes a quarterly expiration. This often leads to increased open interest and embedded tail risk, making it a critical period to watch in the market.
Why does the market often experience a decline after strong spring periods?
-After a seasonally strong spring, the market enters a period that is typically weaker, especially following March Opex. This seasonal pattern can lead to declines as the year progresses.
What are the implications of the resolution of the debt ceiling on financial markets?
-The resolution of the debt ceiling can lead to a decrease in liquidity as the Treasury General Account refills and new debt is issued. This can create a 'whooshing sound' out of financial markets, potentially leading to instability.
How does the market respond to high levels of short positioning?
-High short positioning can lead to market inefficiencies. This can be resolved either slowly over time due to the cost of decay (Theta in options positions) or quickly through a blowoff top where markets rise sharply, forcing short positions to be covered.
What is the impact of the Fed's hawkish stance on the market?
-As the Fed becomes more hawkish, it increases the risk for the market. Higher interest rates can lead to margin compression and an earnings recession, which is detrimental to stock performance.
Why is implied volatility important for market participants?
-Implied volatility is a key indicator of market expectations for future volatility. It affects the pricing of options and can influence trading strategies, such as buying calls to participate in potential market rallies.
What is the potential risk of a stagnation economy as opposed to a deep recession?
-In a stagnation economy, growth remains strong but is accompanied by high inflation and labor costs, leading to margin compression and core stagflation. This scenario is unfavorable for stocks as it does not allow for the interest rate reductions typically associated with a deep recession.
How can investors hedge their positions in a market with increasing risk?
-Investors can hedge their positions by buying calls and shorting stocks. This strategy allows them to participate in potential upside moves while also benefiting from a decline due to the short stock position.
What does the script suggest about the current market conditions?
-The script suggests that the market is in a topping process with a high risk of a fat-tailed event. It indicates that while the market may continue to rally, the underlying risks are significant and investors should be cautious.
What is the importance of considering an investment strategy in the current market environment?
-Given the increasing market vulnerability and potential for a significant shift, it is crucial for investors to consider their investment strategies carefully. This includes evaluating positions, considering hedges, and being aware of the risks associated with current market conditions.
Outlines
📉 Market Trends and Risks in May
This paragraph discusses the common market trend of selling in May and the reasons behind it. It highlights the increased risk due to the expiration of quarterly options and the potential for market declines. The paragraph also mentions the seasonal business activity and the risk of leverage in the market during this period. It emphasizes the importance of being cautious, especially after the Opex period, and notes that the current market situation is different from previous years, with 18 months having passed since the beginning of interest rate hikes. The paragraph suggests that the market is becoming more vulnerable to changes and advises on strategies to manage risk.
💰 Debt Ceiling and Market Liquidity
The second paragraph focuses on the impact of the debt ceiling resolution on market liquidity. It explains that the end of the debt ceiling can lead to a decrease in liquidity as the treasury general account is refilled and new debt is issued. The paragraph also discusses the sticky inflation and the Fed's increasing hawkishness in response to market behavior. It highlights the potential for a market squeeze due to short positioning and the role of implied volatility in market dynamics. The advice given is to consider delta-neutral strategies and to be aware of the risks associated with the current market rally.
📈 Economic Outlook and Market Vulnerability
This paragraph delves into the economic outlook, discussing the potential for stagnation rather than a deep recession. It warns against the risks of earnings recession due to margin compression and the impact of high interest rates. The paragraph also touches on the effects of onshoring and geopolitical tensions between China and the US. It mentions the current market conditions, including the NASDAQ's performance and the implications of a short position. The advice here is to be cautious and to consider the broader economic context when making investment decisions.
🚨 Legal and Investment Disclaimer
The final paragraph serves as a legal and investment disclaimer. It clarifies that the content of the video does not constitute an offer to sell or a solicitation to buy any security or other product or service. It also states that the video is not intended to provide tax, legal, or investment advice. The disclaimer emphasizes that the suitability of securities products or services discussed is not guaranteed for any particular investor and that individuals are responsible for determining their own investment strategies. It advises consulting with business, legal, or tax professionals before making any investment decisions.
Mindmap
Keywords
💡Opex
💡Serial month
💡Tail risk
💡Market liquidity
💡Interest rate hikes
💡QT
💡Inflation
💡Volatility skew
💡Delta neutral
💡Stagflation
💡Market breadth
Highlights
The 'sell in May and go away' mantra is based on historical market trends and risk factors associated with quarterly expirations.
May is a serial month preceding a quarterly expiration, which often leads to increased market risk due to open interest and embedded tail risk.
The decline in February to March 2020 started right after the March options expiration, highlighting the importance of watching expirations closely.
The summer season is typically a liquid period in the market, which can exacerbate risks if leverage has been built up.
This period is different from past rallies as it follows a strong spring season without a February decline, signaling caution.
18 months after the beginning of interest rate hikes, market reactions to these changes are lagging, affecting buybacks and financing.
The rapid QT (Quantitative Tightening) and the Treasury General Account's actions have significant impacts on market liquidity.
The resolution of the debt ceiling can lead to decreased liquidity and potential market issues, contrary to popular belief.
Inflation has been persistent, and the market is not responding to the Fed's actions, leading to a more hawkish stance from the central bank.
Short positioning can lead to market inefficiencies and potential blowoff tops, where markets rise sharply before a decline.
As markets rally, implied volatility typically decreases, skewing the market and potentially leading to short squeezes.
Strategies involving buying calls and hedging with stock can be effective in this market environment, offering participation in upside with downside protection.
The real question for markets is not about a recession but the risk of stagnation with high interest rates and earnings compression.
Current economic data suggests a potential for core stagflation, which is not widely discussed but is a significant risk.
Broad market rallies can hide underlying issues, as seen with the NASDAQ's performance despite a majority of stocks being down.
Technical analysts are signaling potential market exhaustion and deviations, indicating a topping process.
The market's increasing illiquidity and fat-tailed risk present challenges heading into the summer period.
The video content is not investment advice and viewers should consult with professionals for personalized advice.
Transcripts
hello and welcome back to another macro
and update video here we are in May um
Opex is
tomorrow um as we've talked month by
month uh we pointed to this point on the
calendar um for many
months the sell and May and go away
Mantra that many people have heard um is
often generalized and OB fiscated by
many Talking Heads but what are the
reasons this trend tends to
exist couple reasons one quite simply
much like four other months um it is a
month a Serial month that sits before a
quarterly expiration why does that
matter there is a lot of open interest
and embedded tail risk and accelerant a
Tinder Box sitting in these quarterly
aexes whether it's March or June or
September right um the December one has
slightly different dynamic because of
all of the holidays end of year Dynamics
Etc but those other three in particular
all represent areas of risk in the
market something that's not talked about
by many of those Talking
Heads that was something that we saw in
Feb to March 2020 I've talked about this
before the decline that we saw the 30%
plus decline started the day after
February options expiration ended the
day after March options expiration again
not a coincidence important to watch
this expiration
carefully on top of that um this tends
to be uh a period after seasonally very
strong spring period where the majority
of business activity um is
happening um flows of the beginning of
the year extended through the positive
spring cycle uh particularly after March
Opex where you do tend to have declines
again brings us to a seasonally kind of
beginning of a weaker period the summer
itself is a very liquid period so to the
extent leverage has been built in the
system markets have extended there is a
riskof natural uh period that can be
exacerbated during this time so may sell
may go away it's not just a mantra there
are reasons for its General existence
that does not mean the market is going
to decline decline every may but it does
mean the distribution in this window
particularly after you get through this
Opex period becomes more
dangerous this time around it's even
more dangerous than usual
why couple of reasons um if you look at
the data you have years like 2009 and
2020 after big declines that happened
early in the year in that fed March
window where you get real seasonal
strength but those are generally after
big declines and they're after big
declines particularly in the February to
March period
this is different this is not one of
those this is one of those other periods
where we're in a rally and the market is
stretching and we did not get that
decline in February so time for caution
there as well importantly more
importantly we are about 18 months after
the
beginning of the raising of interest
rates that is
about the lag that exists in markets for
reating based on this both for Buybacks
in the equity Market um interest rate uh
changes to financing on the real estate
side I again a lot of projects take a
long time to get
started um Venture Capital uh
private equity rting and the collateral
declines that come with those whether
they're at Banks like we've seen or
otherwise um on top of that the QT which
is much faster acting does not have the
lag has been massed this time around by
the treasury general account and the
debt sealing debates and all the funding
that's been happening as a
result that liquidity that's been pushed
to the market alongside the deposit
insurance that we saw for these small
banks in February will be reversed very
quickly here as we get through the debt
ceiling um ironically everybody is
cheering the end of the debt ceiling
ironically the resolution of the debt
ceiling is actually the problem for
markets it is the the in decreasing of
liquidity from the refilling of the
treasury general account and the release
uh of new uh new debt the the the
raising of more capital that will
ultimately create a whooshing sound out
of financial
markets on top of that inflation has
been sticky and markets are up and the
market is not listening to the Fed so
the FED is increasingly having to be
more hawkish increasingly having to
write those proverbial calls we've been
talking about so all of these things are
lining up at precisely this
window importantly the last couple
months we said that the worst thing that
could happen into the end of this window
would be a squeeze higher there's a
couple of reasons for
that positioning short positioning
ultimately is often the reason that
markets can stay inefficient more longer
than you can stay solvent you've
probably heard that saying
before that's because if there is short
positioning and people know of these
macro flows which that it has been the
case there is a need to shake or Decay
out that positioning and that can happen
in one of two ways it can either happen
slowly with time because of the cost of
Decay on or otherwise known as Theta in
options positions in that type of
positioning to short the market or it
can more often happen through a blowoff
top where markets get positioning gets
squeezed right we create more potential
energy by taking the market higher and
higher we also um get people get pushed
out of positions um as the market goes
higher they're underinvested they look
bad uh on a month over Monon basis
relative to their competition they have
to to buy back shorts or or buy into the
market relative to their
benchmarks and then lastly often VA
becomes unpinned as you go higher we
slide structurally to a slow a lower
implied volatility because calls are
priced on a lower implied volatility
than puts this is what skew in the
market is as the market rallies higher
we naturally slide to a lower vix at
some point that drives buyers back into
the market into these squeezes higher
and that can unpin implied volatility
that dealers own and make markets more
vulnerable release the implied
volatility pin that we talk so much
about and the gamma Supply we talk so
much about we are beginning to and I'll
see that the last two days implied
volatility is beginning to work its way
higher here uh into the last leg of this
rally so all data points to Be watchful
for that does not mean the squeeze will
stop today or tomorrow but it does mean
the market is becoming increasingly
vulnerable what should I do is the next
question should I just go sell all my
assets I have or should I short the
market the answer is there is a much
higher risk reward way of deal dealing
with this at this point implied
volatility has hit its Nat particularly
on the call side as we slide higher now
that implied volatility is naturally
sliding to twoo low of all so you can
participate on increasingly more uh
parabolic move to the upside into a
squeeze by buying calls and you can
hedge those calls with stock delta
neutral this can be used for stock
replacement right which is a very
popular and logical trade at this point
you shouldn't be owning stock and the
downside exposure at this point when
calls andol are so low relative to the
realized and we are getting a natural
increase into a rally of that implied
ball as well and on top of that you can
actually not only get out of your stock
and replace it with calls but you can
just buy calls and get short stock and
that is a longv trade that allows you to
still participate into a an upside move
while still do very well into a decline
because of the short stock something to
really consider for your at home
portfolios lastly it's important to note
that everybody is talking about are we
going to have a recession are we not
going to have a
recession this is not the real question
nor is it the biggest risk for markets a
real deep recession would allow the FED
to come off of the side lines to stop
not only raising rate interest rates but
really begin the dramatic decline that
needs to happen for markets to find a
bottom
um but what if we get a situation where
GDP strength is still quite strong that
we get no recession or a very mild
recession that growth hangs in there
okay all things considered that we get
stagnation not necessarily
recession under those circumstances you
likely with higher interest rates get a
earnings
recession and that is bad for stocks for
obvious reason reasons you get that
margin compression without the demand
Decline and that is ultimately what will
lead to core stagflation and that's
where we believe we're going and very
few people are talking about that but
that's what the data is showing we
continue to hold up well as an econ
economy earnings are getting hit broadly
um there is more and more problems and
stagnation for the economy but not a
deep recession and that will continue to
keep core inflation with labor at still
3.4% unemployment right record but we
added 250,000 jobs last month still
dominant and compressing
margins this is likely going to be
exacerbated by all of the onshoring
that's happening because of the conflict
between the Cold War that's developed
between the China Chinese and the
US it's also being exacerbated Lately by
Dollar weakness OPEC pressure and
needing to refill the
spr and ironically the long-term rates
getting lower uh by 75 basis points in
the last several months is actually very
stimulative to construction and other
deals going going forward so you put all
of these things together and it will
counteract demand it will continue to
keep inflation sticky and hot um while
still not driving a true recession and
that is the worst case because in that
circumstance the FED will continue to
have to tighten or at least hold steady
and
higher the interest rate increases that
it has already done
breadth as many of you have heard has
been awful since February 2nd the NASDAQ
is up over
10% but with only 45 stocks up and 56
down hard to
imagine this is often a very bad
indicator technical analysts such as
demarc who have an incredible track
record over the years not perfect are
also signaling several
big deviations and
exhaustion the market now is more
expensive than it was at the last top at
4822 given where interest rates
are price to sales is near a
record positioning is
short but that is the last remaining
thing to shake and at the end of the day
we can stay irrational for a bit longer
we can rally in the final throws of
these rallies much like we did into that
4822 high in February of last
year but don't be confused this is a
topping
process and broadly the risk is very fat
tailed and what is increasingly an IL
liquid
Market be
water and good luck
heading into the summer take
care this does not constitute an offer
to sell a solicitation of an offer to
buy or a recommendation of any security
or any other product or service by Kai
or any other third party regardless of
whether such security product or service
is referenced in this video furthermore
nothing in this video is intended to
provide tax legal or investment advice
and nothing in this video should be
construed as a recommendation to buy
sell or hold any investment or security
or to engage in any investment strategy
or transaction Kai does not represent
that the Securities products or Services
discussed in this video are suitable for
any particular investor you are solely
responsible for determining whether any
investment investment strategy you
should consult your business adviser
attorney or tax and accounting adviser
regarding your specific business legal
or tax
situation
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