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.

Outlines

00:00

📈 Market Dynamics and the Impact of Option Expiry

This paragraph discusses the significant impact of quarterly options expiry (Opex) on market dynamics, particularly in the final quarter of the year. It highlights the importance of the November and December months, which account for about 65% of the volume-weighted time of the average month. The speaker explains that this period sees less trading activity, leading to accelerated charm and buyback of Delta. The paragraph also touches on the Santa Claus and January effects, which are driven by the large open interest in these months. Additionally, it mentions the influence of increased market valuations on venture capital and private equity, potentially leading to a reinvestment of trillions of dollars at the start of the year. The speaker emphasizes the importance of understanding these Opex cycles and their impact on market behavior, especially in a positive year with volatility compression and higher skew.

05:00

🔄 Market Structure and Volatility Products

The second paragraph delves into the market structure and the role of volatility products such as strangles, puts, and calls. It explains how these products can compress volatility and create a significant skew in the market. The speaker discusses the dynamics of Vana and charm buyback in the context of a steady float and push higher with volatility compression, particularly tied to the S&P 500. The paragraph also addresses the macro liquidity decreasing, which is increasing volatility on the wings, with examples from the tech sector, commodities, and interest rate-sensitive names. The speaker points out the historic dispersion in the market, comparing it to 2017 levels, and hints at the underlying historic events that are unfolding. The paragraph concludes by discussing the macro liquidity and valuations, suggesting that despite the market's upward trend, these factors will eventually prevail, as seen in historical events like the 2000 and 2007 market downturns.

10:01

📅 Navigating the Market's Seasonality and Potential Outcomes

The final paragraph focuses on the upcoming five-week window in October, which is traditionally a period of non-strength or sideways market movement with compressed volatility. The speaker explains that this is due to the market's long position in October and the decay of longer volatility and skew. The paragraph emphasizes the importance of recognizing this period as a potential buying opportunity if volatility remains low. The speaker also cautions that, despite the positive seasonality and time not being a bear's friend, there will be no von and charm flows during this window. The paragraph concludes by advising viewers to be aware of the flows, understand the distribution of outcomes, and be prepared for the market's potential movements. The speaker, Jim Kon Kai, reminds viewers that the information provided does not constitute an offer to sell or a solicitation of an offer to buy any security or service, and that viewers should consult their advisors for personalized investment advice.

Keywords

💡Macro

The term 'macro' in the context of the video refers to macroeconomic factors and trends that influence the financial markets. These include economic indicators, global events, and policy decisions that can affect asset prices and market behavior. The video discusses how these macro factors contribute to the overall market sentiment and seasonal patterns, such as the 'Santa Claus rally' and the 'January effect'.

💡Opex

Opex, short for options expiration, is a financial term referring to the date when an options contract becomes invalid. In the video, the speaker discusses the importance of understanding Opex cycles and how they impact market dynamics, particularly in the last quarter of the year, which is crucial for traders and investors due to the increased trading activity and potential for price movements.

💡Volume Weighted Time

Volume weighted time is a concept used to describe the average time period over which a certain trading volume occurs. In the context of the video, it is used to illustrate that certain months, specifically November and December, have a higher concentration of trading volume, which can influence market behavior and affect investment strategies.

💡Buyback

Buyback, in the financial context of the video, refers to the act of corporations repurchasing their own shares from the market. This is often done to increase the value of remaining shares or to manage the company's capital structure. The video also discusses buyback in terms of options contracts, where the sellers of the contracts (typically puts or calls) are forced to buy back the securities they sold, which can impact market dynamics.

💡Vana and Charm

Vana and Charm are likely misspellings or shorthand for 'VIX' and 'charm', which refers to the CBOE S&P 500 BuyWrite Index. The VIX is a measure of market volatility and is often called the 'fear index', while the BuyWrite Index represents a strategy of holding stocks and writing call options against them. In the video, these terms are used to discuss market volatility and its impact on investment strategies, particularly around options expiration.

💡Structured Products

Structured products are financial instruments that combine various features of other securities, such as stocks, bonds, and derivatives, to create a new investment with specific risk-return characteristics. In the video, the speaker discusses how the supply of structured products has increased with higher interest rates, leading to shifts in market behavior and investment strategies.

💡Volatility Compression

Volatility compression refers to a decrease in the implied volatility of options or other financial instruments. This can occur when there is a general expectation of lower price fluctuations in the market, leading to a reduction in the premium investors are willing to pay for options. In the video, the speaker discusses how increased supply of certain financial products can lead to volatility compression, which can impact market behavior and investment strategies.

💡Skew

In finance, skew refers to the asymmetry in the distribution of returns for a security or market. Positive skew indicates that the potential gains are greater than the potential losses, while negative skew suggests the opposite. In the video, the speaker talks about how certain financial products and market conditions can create a significant skew, particularly in the market's options strategy, which can influence market movements.

💡Macro Liquidity

Macro liquidity refers to the overall level of liquidity in the financial system, which is influenced by factors such as monetary policy, economic conditions, and market sentiment. High macro liquidity typically means that assets can be easily bought and sold without causing significant price changes. In the video, the speaker suggests that despite the current positive market trends, negative macro liquidity and high valuations could eventually lead to a market downturn.

💡Calendar Month

A calendar month refers to any of the twelve months of the year as per the Gregorian calendar. In the context of the video, the speaker uses the term to discuss the seasonal patterns in the financial markets, particularly how certain months, such as November and December, tend to have higher trading volumes and thus can influence market behavior and investment strategies.

💡Santa Claus Rally

The Santa Claus Rally is a seasonal pattern observed in the stock market, which suggests that stocks tend to rise in the last two weeks of December and continue into the first two weeks of January. This phenomenon is attributed to various factors, including end-of-year portfolio adjustments by institutions, positive sentiment, and reduced trading volume during the holiday season. In the video, the speaker discusses this rally as part of the broader seasonal market dynamics.

💡January Effect

The January Effect is a theory in behavioral finance that suggests that stock prices tend to rise in the first few days of January due to various factors, such as investors reallocating their portfolios, the settling of year-end bonuses, and the beginning of a new tax year. In the video, the speaker includes the January Effect as part of the positive seasonal trends that investors should be aware of, especially in the context of options expiration and market liquidity.

Highlights

The transcript discusses the importance of the quarterly Opex and its impact on market behavior, particularly in the final quarter of the year.

November and December months account for about 65% of the volume weighted time of the average month in the calendar year, indicating less trading activity at baseline.

Accelerated charm and vanca flows, as well as accelerated buyback of Delta, are expected in the final quarter due to the reduced trading time.

December and January have the biggest open interest Opex in the equity land, with December being the largest due to leaps.

The Santa Claus and January effects are driven by the buyback of structure products and the high volume in these months.

Markets are up almost 20% for the year, leading to an increase in the value of the equity market by about $8 trillion.

Venture Capital and private Equity are tied to public market numbers, which can cause an increase in collateral across the market.

There's an estimation of about $450 trillion of long assets tied to public asset valuations, which could lead to significant reinvestment at the start of the year.

The transcript mentions the potential for a significant buyback at the first of the year, especially given the market's liquidity.

The Santa Claus rally and the January effect are positive seasonal pushes that historically occur at the end of the year and the beginning of the next.

Understanding the Opex cycles and when these flows happen is crucial, especially in a positive year with volatility compression and higher skew.

The transcript highlights the impact of higher interest rates on structured product supply and investors' preference for higher yield investments.

Simple naive structured products are selling out of the money strangles, puts, and calls, which compress volatility and create market skew.

The transcript notes historic dispersion in the market, comparable to 2017 levels, indicating significant underlying market movements.

Despite the market's apparent placidity, there are significant macro liquidity and macro flow issues that could lead to a market downturn.

The transcript references past market bubbles and their eventual crashes, emphasizing the cyclical nature of markets.

A specific date, January 17th, is highlighted as potentially significant for market movements, based on the analysis of these flows.

The transcript discusses the five-week window in October, which is typically a period of market consolidation and lower volatility.

The transcript advises being cautious and flexible in the market, particularly in light of the positive seasonality and potential market movements.

Transcripts

hello and welcome back to another macro

and flows

update here we sit at September

quarterly

Opex it's a big one we've talked about

it for some time but unlike some of the

other uh

aexes we are now

reaching um a important reflexive Point

here as we get to the final quarter of

the

year um November and December months

have about 65% about 2third of the

volume weighted time of the average

other months of the calendar year what

does that mean that means there's

simply less time less trading

activity um at Baseline that means

there's accelerated charm and vanaf

flows accelerated buyback of Delta it

also uh with December and January which

are the biggest open interest um Opex is

um in in the equity land the December

being the biggest because of leaps that

were listed year-over-year that are now

coming uh to um fruition as well as in

January end of the year um for most

single list equities those expirations

have more

skew and more open interest uh more more

volume which ultimately drives more

buyback uh in terms of structure

products Etc into the end of the year

that's a massive component of what we

call the Santa Claus and January effects

the other maybe even bigger part uh

particularly in an upe is that when

markets are up which they are almost 20%

for the year like they are now the

equity Market which is about 40 trillion

values up by about $8 trillion so many

things Venture Capital private Equity

are also tied to those public numbers

which can cause an even higher amount of

collateral increase across the market

by some estimations there's about $450

trillion of long assets many of which

are are are tied to valuations in public

assets if those all increase by 20% for

the year that's 9 trillion now these are

probably significant overestimations the

amount of uh increased collateral and

this collateral doesn't all get

reinvested uh at the first of the year

obviously each month there's a

reinvestment in many these cases but if

even five % of the 9 trillion right has

to be reinvested you know we're talking

about $45 trillion doll a really crazy

number of of a a buyback that has to

happen at the first of the year

especially given about 75 billion only

75 billion determines the Daily net move

in the markets markets are quite liquid

so that coming um by uh by uh into the

first of the year is is a major driver

of what is the most profitable four

weeks of the year um historically the

Santa Claus rally which is the last two

weeks of the year and the uh first two

weeks of the year which is often

referred to as the January effect those

are coming people realize that there is

also less volume weight of time as I

mentioned you put those things together

what do we get a very positive seasonal

push these are the things that un

undermine that that determine the

seasonality that's so critical but it's

not just the calendar month of December

or the calendar month of January you

really have to understand these Opex

Cycles when these flows happen in that

cycle but they are things that you do

not get in front of particularly in a

significantly positive year with v

compression and higher skew all of which

we're seeing this

year to that V compression Point I've

talked about this a significant amount

the last several months it's a critical

piece for people to

understand with higher interest rates

we're getting sign significantly higher

structured product Supply that means and

people are leaving the stock market in

favor of things that where they can get

5 a half% yield plus stack some type of

um of non-correlated return in the

markets uh that often means selling B um

and with simple uh naive Structured

Products um there's ENT things yielding

8 n% right um non-correlated uh that

that are selling significantly out of

the money um strangles puts and calls a

lot of these uh these products um not

only compress volatility but a lot of

them tend to sell more call or at the

money uh V or implied VA these uh

positions C can sometimes also buy not

sell the put side this creates a

significant skew um in the market as

well compressed volatility with high

skew is exactly the most powerful uh

Dynamic uh for for Vana and charm

buyback um so so that that setup

continues to mean this steady float and

push higher and Vol compression

particularly tied to the S&P 500 which

does not mean the whole Market is not

volatile if anything macro liquidity

decreasing is increasing volatility on

the wings um in in uh whether it's in in

Tech uh you know AI um or commodities or

interest rate sensitive names we're

seeing a significant amount of

volatility around the center massive

rotations historic rotations that are

not just a function of changes that are

happening in liquidity and macro um

effects which is the first order thing

that most people think about but it's

really a function and being exacerbated

by the fact that b is pinned

specifically at the index level but not

outside of the index level uh we are

getting what's called dispersion and

they got historic dispersion in line

with

2017 which is the last time we saw

something even close to these numbers

the only time um about 30% higher

dispersion uh than any other time in 150

years of Market history so really

historic things are happening um

underneath the hood but it seems at the

from the from the top of the market that

it is a very Placid uh simple Market

that just happens to go higher for some

fundament a reason that people don't

understand the truth is that the macro

liquidity the macro flows are

significantly negative eventually given

these valuations those will win out much

like it did in 2000 and in 2007 and

again at other points like that in

history but um the way these moves end

can be significant and positive U and

last significantly longer than most

people expect um I was here in 99 and

everybody knew in 9899 there was a tech

bubble but it took another

90% plus of the market almost again

doubling in the NASDAQ um into 2000

before the market declined

92% similar um in 2007 uh and 2006

significant rallies despite what

everybody knew was a housing bubble that

would eventually crash um we can go

through these examples again and again

the co crash which I've talked about

rallied January into mid-February we

knew about Co that whole time before

crashing 30% in a month so not to scare

people but the structural liquidity is

very bad valuations are very high uh the

liquidity uh you know what tends to

happen in these scenarios um is a draw

down in markets um and a and a

Readjustment but it doesn't go in a

straight line often ends in a blowoff

top we believe that's likely coming

still um and no better time into uh

November and December and early January

I would circle on your calendar January

17th those that have been with us for

some time will recall that we we very

much called starting all the way back in

August of 21 the almost to the day the

top in in the in February

22 um uh we were able to do that as a

function of these flows um over 4 months

in advance 5 months in advance um we do

believe that Jan 17th date is very very

important again especially conditionally

if we continue to see a push up during

this period which we believe we will and

something that either approaches or

exceeds all-time highs in this window

that would be the perfect setup right as

we get into and P this January effect

for some type of significant draw down

in the market that said it's a election

year and we'll have to see what the

Dynamics look like at that point is V

still structurally very well supplied or

has that blowoff top really stretched uh

the market in a way that has a booed v

um particularly in the back end of the

curve and could create an unpinning

we'll have to see as we get to that

point but if all of the the things that

we're looking for the check marks that

we're looking for uh to to fit the

Criterion of of a setup that that could

be the final push before a decline um

are potentially there looking forward

but first things first we have a

five-week window coming here in October

uh there is uh a window of weakness

which we all know right I've been very

clear is actually a window of non

strength more than it is weakness um

what that tends to mean is markets in

that period are more likely to go

sideways and V is more likely to be

compressed you can get VA events where

things Spike lower in these

windows but this time as I've mentioned

V is very well supplied implied into

October uh most of the market is has

been long October and November and

December Vol implied volatility which

has been cheaper relative to September

which has been very high so people are

decaying institutions are decaying

longer V longer skew shorter Delta

that's what causes this push in this

window that we've seen the last several

days and several weeks um if we get to

the back half of of of this uh this

month uh the back couple days if we get

into the the end of this month uh and

have yet to see any significant

volatility or an increase in implied

volatility you can expect that these any

dip would be a buying opportunity in

this window that said it's a two-e

window to take seriously there are uh

going to be no von and charm flows

during them particularly because it's a

five-week window but you have to be very

cognizant that behind that sets very

positive

seasonality and uh time is not a bears

friend I've said that again and again

particularly true here given the net

positive flows that are coming Behind

These flows often markets don't wait for

that moment um and given what we're

seeing which is significant V Supply and

increasing Vol Supply um short Delta

that needs to be hedged um we believe

the odds of some type of a tail are

increasingly unlikely in this window um

unlike what we've seen in other windows

um so that being said I think as always

it's uh it's important to to know those

flows exist understand the distribution

that there is a left fat tail but

increasingly a very right distributed

set of outcomes and uh no better time

here at the end of September to be water

and to be flexible going forward wishing

you all the best this is Jim Kon Kai

volatility

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