Macro and Flows Update: May 2023 - e17

Summary

The 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

00:00

📉 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.

05:00

💰 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.

10:01

📈 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.

15:03

🚨 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.

Keywords

💡Opex

Opex, short for options expiration, refers to the date when options contracts become void. In the context of the video, it is a critical time that can influence market behavior due to the high open interest and potential for increased volatility. The speaker mentions 'sell and May and go away' as a mantra that highlights the historical tendency for the market to decline after May Opex, signifying a period of potential risk for investors.

💡Serial month

A serial month is a month that precedes a quarterly expiration, which typically includes March, June, September, and December. In the video, the speaker explains that these months are significant because they are associated with high levels of open interest and tail risk, making them potential periods of market instability. May, being a serial month, is flagged as a time when investors might consider reducing exposure to the market.

💡Tail risk

Tail risk refers to the possibility of an unlikely but highly consequential event occurring that can significantly affect the market. In the video, the concept is used to describe the potential for large market movements that are out of the ordinary and can result in substantial losses for investors. The speaker notes that serial months before quarterly expirations, like May, have embedded tail risk due to the high open interest.

💡Market liquidity

Market liquidity refers to the ease with which assets can be bought or sold without affecting the asset's price. In the video, the speaker discusses how the summer months are typically periods of high liquidity, which can mask underlying risks in the market. However, if leverage has been built up in the system, a natural period of lower liquidity could exacerbate market risks.

💡Interest rate hikes

Interest rate hikes refer to the increase in interest rates by a central bank, like the Federal Reserve. In the video, the speaker notes that they are about 18 months after the beginning of interest rate hikes, which can have a lag effect on markets, influencing buybacks in the equity market and financing in real estate.

💡QT

QT, or Quantitative Tightening, is the process by which a central bank reduces the size of its balance sheet, typically by selling assets it has previously purchased. In the video, the speaker explains that QT has been faster acting than previous measures and has been influenced by the Treasury General Account and debt ceiling debates, affecting market liquidity.

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. In the video, the speaker notes that inflation has been persistent, or 'sticky', and the market is not responding to the Federal Reserve's actions, leading to a more hawkish stance by the central bank.

💡Volatility skew

Volatility skew is a phenomenon in options markets where the implied volatility of calls and puts differs, often with calls being priced with lower implied volatility than puts. In the video, the speaker discusses how the skew can lead to a natural slide to lower implied volatility as the market rallies, which can attract buyers and potentially lead to a short squeeze.

💡Delta neutral

Delta neutral is an options trading strategy where an investor's positions have a net delta of zero, meaning the overall sensitivity to changes in the underlying asset's price is neutralized. In the video, the speaker suggests using delta neutral strategies to participate in potential market moves while managing risk, such as buying calls and hedging them with stock.

💡Stagflation

Stagflation is an economic situation characterized by stagnant economic growth, high unemployment, and high inflation. In the video, the speaker suggests that the current economic conditions may lead to a form of stagflation, where core inflation remains high due to labor costs and margin compression, without a deep recession to reset the economy.

💡Market breadth

Market breadth refers to the number of stocks participating in a market advance or decline. In the video, the speaker points out that recent market gains have been narrow, with the NASDAQ up over 10% but only with 45 stocks contributing positively, indicating a potential weakness in the market's overall health.

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