Macro and Flows Update: September 2023 - e21

Summary

The transcript discusses the impact of quarterly options expiration (Opex) on market dynamics, particularly in the final quarter of the year. It highlights how the reduced trading activity in November and December, coupled with high open interest and volume in these months, leads to accelerated charm and vanna flows, as well as buyback activity. The script also touches on the Santa Claus and January effects, market performance, and the influence of venture capital and private equity on market valuations. It further explains the structural liquidity issues and high valuations, suggesting a potential market drawdown in the future despite the positive seasonality and time-weighted factors that typically drive market performance upwards.

Takeaways

• 📈 The script discusses the impact of the Options Exchange (Opex) on market dynamics, particularly in the last quarter of the year, highlighting that November and December have about 65% of the volume weighted time.
• 📊 The end of the year sees accelerated charm and vanca flows, with December and January having the highest open interest due to the listing of leaps and year-end expirations.
• 💹 The equity market's valuation increase, driven by a nearly 20% rise for the year, affects venture capital and private equity, potentially leading to a significant collateral increase across the market.
• 🔄 The script suggests that a portion of the increased collateral might need to be reinvested at the start of the year, leading to a massive buyback and market push.
• 📅 Historically, the Santa Claus rally and January effect are positive seasonal pushes, occurring in the last two weeks of December and the first two weeks of January.
• 💰 The script mentions a significant amount of structured product supply at higher interest rates, leading to a shift in investment from the stock market to products offering higher yields.
• 📉 Despite market liquidity, there's an underlying structural issue with high valuations and negative macro liquidity, which could lead to a market drawdown and readjustment.
• 🚀 The script references historic rotations and dispersion, comparing the current market situation to 2017 and other significant points in market history.
• 📆 A specific date, January 17th, is highlighted as potentially being a critical point for market change, based on previous analysis and observed market flows.
• 🌀 The upcoming five-week window in October is expected to be a period of market non-strength, with compressed volatility and a tendency for markets to move sideways.
• 📈 The script concludes with a reminder of the importance of understanding market flows, being prepared for market movements, and maintaining flexibility in investment strategies.

Q & A

What is the significance of the final quarter of the year in terms of trading activity?

The final quarter of the year, particularly November and December, is significant because it has about 65% of the volume weighted time of the average month in a calendar year. This means there's less trading activity, which can lead to accelerated charm and vanna flows, as well as increased buyback of delta.

Why does December have the largest open interest in the equity land?

December has the largest open interest in the equity land because of the leaps that were listed year-over-year, which come to fruition at the end of the year. Additionally, it's the biggest month for options expiration in the equity land, which contributes to the high open interest.

What is the impact of a market that is up on venture capital and private equity?

When the market is up, as it is almost 20% for the year in the script's context, it leads to an increase in the value of the equity market by about $8 trillion. This can cause a higher amount of collateral increase across the market, affecting venture capital and private equity, which are often tied to those public numbers.

How does the increase in collateral affect the market at the beginning of the year?

The increase in collateral, even if a portion of it needs to be reinvested at the beginning of the year, can lead to a significant amount of buyback, impacting the market. For instance, if 5% of an estimated $9 trillion increase needs to be reinvested, it would result in about $450 billion of buyback, which is a substantial force in the market.

What are the Santa Claus and January effects?

The Santa Claus and January effects refer to the positive seasonal push that occurs at the end of the year and the beginning of the next. Historically, the last two weeks of the year and the first two weeks of the year tend to see a rally in the markets, which is influenced by factors such as less volume weight of time and the aforementioned buyback activities.

What is the impact of higher interest rates on structured product supply?

With higher interest rates, there is a significant increase in structured product supply. Investors may leave the stock market in favor of products that offer higher yields, such as 5.5% or more. This shift can lead to changes in market dynamics, with people seeking non-correlated returns in the markets.

How do naive structured products affect market volatility?

Naive structured products, which often yield 8% or more and are non-correlated, can significantly affect market volatility. These products tend to sell out-of-the-money strangles, puts, and calls, which can compress volatility and create a significant skew in the market. This combination of compressed volatility with high skew is a powerful dynamic for vanna and charm buyback.

What is the significance of dispersion in the context of market history?

Dispersion refers to the difference in performance between various segments of the market. Historic dispersion, as mentioned in the script, can indicate significant market shifts. For example, the dispersion levels mentioned are in line with 2017 and are about 30% higher than any other time in 150 years of market history, indicating that historic events are unfolding beneath the surface of the market.

How does macro liquidity affect market movements?

Macro liquidity plays a crucial role in market movements. Decreasing macro liquidity can increase volatility, especially in sectors like technology, commodities, and interest rate-sensitive names. While the overall market may appear calm and simply trending higher, underlying macro liquidity and macro flows can significantly impact the market's direction and valuations.

What is the expected market behavior during the five-week window in October?

During the five-week window in October, the market is expected to be more sideways with volatility likely being compressed. This period is known for being a window of non-strength rather than weakness. If there is no significant volatility or increase in implied volatility by the end of the month, any dip during this window could be seen as a buying opportunity.

What does the script suggest about the market's future?

The script suggests that while the market may continue to push higher during the specified period, it is essential to be aware of the underlying dynamics, such as structural liquidity issues and high valuations. It indicates that significant market drawdowns can occur, but they may not follow a straight line and could end in a blowoff top. The script also highlights the importance of the January 17th date as a potential turning point.