Heading into Tuesday’s plunge, there was a veritable cornucopia of excuses (which traders had generously ignored) to resume last week’s deleveraging as investors were already anchored to more tangible market headwinds:
- Lack of progress on CARES 2.0 (consensus still sees $1.5-$2T getting passed although even Goldman is becoming more skeptical)
- Gamma reset in megacap Tech due to the SoftBank doxxing (massive upside vol structures should begin to roll off, however)
- Record equity issuance upcoming ($308B so far YTD in the US or the 100th %-tile back to 2008)
- September trading seasonality (see MSZZMOMO SEAG on Bloomberg)
- Diminishing systematic bid (Morgan Stanley now sees only a few $B of global equities to buy vs prior growth estimates)
- Diminishing bid from retail (next round of stimulus checks may matter)
- Elevated HF exposure (nets and gross at the 66th and 89th %-tile per MS PB Content)
- Mutual fund year-end (will we finally see outflows/profit taking if tax loss selling was pulled forward in August?)
- Election permutations (Senate races should remain in focus for those in fear of new tax proposals)
- US-China re-escalation (hence focus on SMIC over the weekend)
- Setbacks in the reopening (second wave?)
Yet despite Tuesday’s violent sell-off, with vols already massively elevated in the market largely due to the now notorious SoftBank gamma gamble and “riding down the skew” as the market sold off, we saw “enormous pressure on vols” which finished significantly lower across the term structure and across products (incidentally, had SoftBank not been in the market, it is certain that the VIX would have closed far higher). And while flows were generally quiet, Morgan Stanley’s trading desk “did see some accounts coming in to fade the weakness by selling puts, notably in the tech space” suggesting that gamma is close to neutralizing.
Confirming these observations from Morgan Stanley, Nomura’s Charlie McElligott adds that “through the course of yesterday’s US Eq session, we began seeing a number of tactical clients take profits in their downside trades and pivot into various “buy the dip” expressions (e.g. selling QQQ Puts, AAPL CS 1x2s, Riskies), playing options for a bounce.”
This, as the Nomura cross-asset strategist points out, “is healthy: vols were finally hit meaningfully lower with term-structure flattening powerfully and Skew smashed on account of the Put Wing coming off sharply” as traders are now playing options for a bounce (SoftBank copycats?)
Which brings us back to Morgan Stanley, which writes that while the Nasdaq tumbled almost 5%, momentum was down just 66 bps, while Tuesday’s outperformance of the 12-month leaders, MSQQUMOL, vs. QQQ, was the largest it has been in more than 2 years (1.8%).
As the bank further notes, “the expectation is that Momentum should be down more, given Tech’s sell-off and in light of the spike in volatility from the Long leg of Momentum the last month. However, it is not uncommon for Momentum to be higher during large QQQ sell-offs. Over the last 2 years, Momentum has been positive more than half the time QQQs were down -3% or more.”
The underperformance of QQQs to Momentum, and other expensive, growth proxies, is the combination of 3 things:
- Underperformance of mega-cap Tech
- Energy lagging and other net underweight skew in MSZZMOMO
- The rally in re-opening oriented trades
In other words, not only is SPX underperforming IWM, but it’s the large cap Tech really driving the move in QQQs. Of the -4.7% move in QQQ today, FAANMG + TSLA are responsible for 65% of the move. Their combined weight in QQQs is ~50%. Meanwhile, these same names are just 5.5% of the MSQQUMOL index, which limits their impact on the broader Momentum factor. The increased volatility of these mega-caps shows up in the chart below. Equal-Weight QQQs (MSXXEWQQ) has outperformed FANG+ by 4.5% the last week after a 1y of consistent underperformance.
Aside from mechanistic kneejerk reactions, McElligott then adds that we are now seeing the “right kind of washout” movement in Nasdaq dealer Gamma and Delta, which as first observed yesterday, was “absolutely shattered” into negative territory and extreme (low) rank: as shown below, Gamma is now -$238.7mm tumbling to just the 9.7 percentile, while Delta is -$12.6B at just 4.5 percentile. In other words we have gone from one delta extreme to another.
Away from the Nasdaq, greek action is much more sane too, with McElligott noting that for consolidated SPX/SPY options dealer Gamma has also turned negative at -$1.9B and 22.8%ile with Delta $138.1B, totally middling at 55.9%ile.
Picking up on last week’s note from Goldman pointing out the massive spread between realized and implied vol (which was largely a byproduct of SoftBank’s action), the Nomura strategist observes that this “tug of war” on the Vol Control “flow sequencing” is going to be a close call “because 1m realized is rapidly catching up to 3m realized—and as we look at the max of the two, this will matter the near-term fate of their exposure maintenance.”
This is important for vol targeting funds such as CTAs and risk parity in determining what they end up doing next, and according to Nomura, currently 3m realized vol remains the primary vol-control input, “and despite yesterday’s VC strategy selling and likely incremental follow-through today, the drop-off of the 6/11/20 -5.9% SPX day from the 3m realized lookback window, we would expect to see a large mechanical releveraging off the removal of that point alone, with very large buying imminently (tomorrow).”
That said, Charlie hedges by pointing out that after this imminent “buy” and its residual impact, “the recent violent adjustment higher in realized (catching up to implieds) will likely mean that we should expect that this recent 3-4m “latent bid” in futures from VC strats likely turns into at least a medium-term supply source thereafter (selling futures to lower exposure vs tgt) and especially if the 1m overtakes the 3m” unless in a reversal of the moves seen in August, we see vols correct lower quickly with market consistently “higher” again, which however even with the SoftBank effect now off the table, seems somewhat unlikely due to the nature of election proximity and likelihood that vol dealer risk toleranace will continue shrinking into the event risk, resulting in “increasingly erratic pricing and likely sticky tails at the very least.”
Vol control funds aside, McElligott concludes that “it is particularly critical that we see NQ leading the charge today where we are already up some solidly in futures, while WTI has also stopped its “brutal bleed” from yesterday as discussed earlier.