Gamma Rama

I'm guessing that the closure of many of the world's casinos has driven gamblers into playing the stock market. The August melt-up in the stocks of mega cap plays like Apple and Tesla, captured the interest of option players like never before. And trading options is like the $1,000 table of risk taking.

Now, to the surprise of no one, the dangerously narrow 'Covid beneficiary' rally has come to a crashing halt. The bubble has burst. But for the many stock market doubters, it is a pyrrhic victory at best. What good is saying you haven't owned Tesla - down a quick 25% in three days, when it is still up 300%+ since March? The arithmetic of this is frustrating to say the least.

A while it was popular to blame the Robinhood crowd for all the froth, there is now another culprit being accused of stoking the hype in FANG through massive and speculative call option buying.

Softbank, has now being unmasked by the FT and Zerohedge as the speculative pyromaniac, reportately pouring gasoline on the big tech rally fires. Softbank's leader, Masayoshi Son, with the help of his messianically promoted Vision Fund, appears to have gone all-in on the single stock options market, buying up billions in call options. The likes of TSLA, AAPL and AMZN were disproportionately represented in those strategies as the momentum mania dominated the tape.

The counterparties to these trades are the options market makers who, having written call options to Softbank, hedged their shorts with massive 'long' stock positions. Here's where it gets tricky. Those same dealers are now are forced to reduced exposure due to the effects of gamma - the 'second derivative' of implied volatility. They are "over-hedged" and are then forced to sell stocks in a falling market. Softbank, aka the 'NASDAQ Whale', has disrupted the market with devastating effect. Over 70% of option activity was in calls versus puts - a sentiment 'tell' if I've ever seen one.

Who knew that a single buyer could have such an effect? Well I did, actually. Buy pointing out the lack of volume going into stocks - using the Chaikin indicator - you could see the lack of conviction for the market. (pls re-read last week's note for more)

Market volume is like votes in an election - the strength of conviction is evident from election turnout and popular vote measures. I was highly skeptical of the recent advance because of the lack of volume corroboration. That has now come back to bite.

Obviously both the Robinhood and the Softbank effects are only partially to blame for the debacle that is currently unfolding. These investment pools are but a fraction of total market capitalization.

More importantly, they reflect a 'fever breaking' effect. When the narrative changes, like it did when the S&P decided against including TSLA in their index, a sea change happened. And with the Nasdaq at record levels on the back of the few Covid beneficiaries, a bit of profit-taking is more than justified.

The signs were there. "Met my target, raise my target' thinking on the part of trend following analysts pervaded the later stages of the market's rise. The shear blatant stupidity of 'investors' chasing stocks higher on stock split announcements was unsustainable. With the plug variable in all this being valuations, a huge downside risk developed.

So is my rotation call still valid? Should you buy the dip here? Is this just an air pocket?

The valuation argument, combined with the possibility of a post-Trump, post-Covid narrative, is enough for me to be an optimist about the prospects on a rotation to value. But there are still risks. There's many a slip between cup and lip.

With a new round of China bashing, the lack of a fiscal deal (Trump advisor, Larry Kudlow says "we can live without it") and the very real threat of a true second wave of viral infections when the indoor season ends, there are more than enough reasons to be wary of going 'all in' on the market. The election outcome is far from certain given the polarized make-up of the arcane U.S. Electoral College. And the roll-out of a credible, widely accepted vaccine is being treated as a political tool.

I will be watching two things when stocks bounce, possibly as soon as today at 11. (That, for me, would be so 'on brand' !).

First, the cyclical/value trade, currently showing signs of emerging relative strength, would have to lead the rally. I find that scenario remote, given the decelerating economic backdrop. Renewed shutdowns have been announced in Europe and it is only a matter of time before such measures are implemented here, especially in the schools system.

The "K" shape of the recovery is leading to an equally uneven consumer income rebound. The fact that asset prices are higher, is actually slowing the rebound in housing market in the critical entry level demographic. And when does 'dining in' become a thing again?

More likely we will see a dead cat bounce for the tech wreck group. The sharply oversold favourites like Zoom and Peloton will still have lots of new fans, eager to buy the dip despite their nose-bleeding valuations.

Second, the treasury curve would need to show signs of steepening. Fed Chair Jerome Powell's pledge to tolerate higher inflation has been met with scepticism so far. Deflationary forces still dominate the global economy, as evidenced by oil's plunge today. For this narrative to truly take hold, we would need to see real progress in the economic recovery, not the funny-money government stimulus induced version, seen to date. With a yield curve so flat, cyclicals, and most importantly financials are unlikely to lead the charge.

So a tricky trading environment is shaping up as we head towards a very uncertain future in Q4.

Just one question .... when's Casino Rama gonna open?

Risk Model: 3/5 - Risk On

With the upcoming reading from the AAII survey not due until Thursday, the model is likely to go into 'sell' mode should the readings reflect the angst-generating sell off that started late last week. My poor model has been slow footed again.

Importantly, the Copper/Gold ratio is holding up well in the face of what should have been huge 'flight-to-quality' event. Gold became a highly popular trade, accelerated by recent and strange aversion to U.S. dollars. Really, I don't see what the rush to by Euros was all about. Brexit is now a complete debacle and they still have negative rates over there.

The upshot of all this should be a bounce trade, starting today. The lack of a meaningful signal from credit markets comforts me that this sharp correction is likely a 'shot across the bow' type sell-off. But it is only a trade, given the risks from an overvalued, narrow market. Value players will still need an abundance of patience.