Before you get too swept up in the prospects for a squeeze higher in equities into year-end, don’t forget that the confluence of bullish technicals which have variously conspired to ignite a powerful rally of the late October lows are playing out against a backdrop of tightening financial conditions.
That’s the message from Nomura’s Charlie McElligott, whose recent notes have revolved around the dynamics that have helped the S&P log four sessions of >1% gains since October 29.
Those dynamics, you’re reminded, entail hedge funds and asset managers being forced to buy after low-ticking their exposure on October 29, just prior to the rally that saw stocks close out an otherwise abysmal month with the best two-day gain since February. Those fundamental investors were caught flat-footed just as the systematic crowd (e.g., CTAs) and macro funds started to re-risk. That, McElligott argues, catalyzed a grab for exposure. To wit, from a note out Wednesday:
The “fundamental” active Equities universe then has essentially become a source of synthetic “short gamma” in the market, as with any rally in stocks, said performance-burned funds effectively “get shorter” the higher Equities travel, in turn contributing to these violent bear market rallies on “up” days, with funds grabbing exposure “dynamically hedging” futures on said move.
Between that, expectations for further systematic re-risking and buybacks, there’s scope for a tactical rally into year-end. That thesis was echoed this week by JPMorgan’s Marko Kolanovic.
But again, McElligott doesn’t think you should lose track of the larger, overarching narrative.
“Even with this +8.3% rally off last week’s lows to yesterday’s SPX highs, DO NOT be mistaken—we remain immersed within the ‘financial conditions tightening tantrum’ end-of-cycle phase”, Charlie writes on Friday, adding that “U.S. 5Y real yields sit at highs since early 2009, corporate credit Baa-10Y yield spread is 45bps wider off early February levels and the 90-day commercial paper-3m T-Bill spread has nearly tripled to +27bps since early September levels”.
