Charlie McElligott – Food For Thought

Dropping the overnight cacophony of noise out of UK Brexit rulings, ECB headlines and US poll updates…I want to instead discuss trader mindset over the past week and into next week and thereafter.


ELECTION SCENARIO FEEDBACK: I have spent the vast majority of the past week engaging some of our brightest clients in my feedback loop on (completely unsurprisingly) US election scenarios.  Here are a few key bulleted observations:


–Overall largest take-away was that this de-risking in stocks has been so orderly and grinding due to the buyside’s lessons from underestimating Brexit possibilities in June, EVEN THOUGH the odds are still in the favor of the perceived “market positive” HRC outcome.  This de-risking is thus a “slow-bleed” and not a panic-grab, as Brexit was much closer to a true “toss up” going into the vote, versus this still likely ’70 / 30’ probability for HRC.  Recall, folks were taking nets HIGHER days into that event-risk.  As you’ll see below, the performance of thematic baskets in my monitor yesterday shows that longs have been taken-down rather precipitously (although somewhat surprisingly that some shorts are currently being added to as highlighted in recent days).  I would add another complication is the timing with “peak earnings” idiosyncratic risk, which has been showing us a number of outsized price reactions, and as such is adding to an overall desire to ‘gross down’ over the longer past week time frame.


From a vol perspective, for net exposure at HFs to be cut so low so fast, and for cash to be so high now at MFs heading into the event, it makes some sense to me that there is less “panic grab” for VIX upside simply because folks aren’t all that long / don’t have that much to protect now.  That said, there are certain products and lines where the vol is rich and straddles are pricing in some large moves which I will touch-on later.  And also pretty simply, as VIX is calculated based upon 4th and 5th week SPX options strip…and as this is a ‘one week out’ event, it’s just not being “picked up.”  Thus “VOL OF VOL” (VVIX, convexity) is showing far greater relatively movement than the “underlying” VIX.  As such, “vol of vol” is probably the best sale of all (sell VIX straddles).


–Outcome-wise, all were of consensus view that you can now throw-out the ‘risk’ of a Democratic sweep…a scenario that was a very real threat as of last week at this time.  Too much momentum has been lost in the past week.


–Ironically (with regards to the swing from one end of spectrum to other), there now is a view that the seeming momentum in the Trump camp could actually create a scenario that was previously “zero delta” which is now a “non-zero” probability of a “Trump Presidency / GOP Congress” regime could produce a “right tail” economic scenario–where the tax plans and deregulation movements could get more economically provocative for both individuals and small businesses.  Again though, this remains low probability.


There was a relatively widespread view that in the case of an HRC win (where the probability was perhaps ‘down to’ 60 / 40 yday, although some might say that lack of further surprises and even stabilization per the new earlier-referenced WaPo tracking poll would see that more like a return to 70 / 30 odds in her favor as of today), that there might be a +2% upside from here on a relief-rally, as markets would essentially claw-back what has been lost over this very calm de-risking bleed. 


–There was dissent on “where to from there (an HRC win)” as a number of folks are pushing outright “return to bull market” case—with this moving from a ‘rates / monpol’ focused equity backdrop transitioning to an ‘earnings-driven’ one.  My pushback there remains that earnings probably haven’t moved the needle enough to re-rate stocks against the headwind that comes in the form of higher rates and their impact on the ERP.  Equities still feels “stuck” to me, even after a likely ‘relief rally.’


–Regarding a Trump win, there was some debate on the next day SPX drawdown (-2% to -3% was the general ‘max’ view, with one outlier -5%), but nearly all agreed that there was a desire to ‘buy it.’  One would come from perceived “Brexit FX benefit,” i.e. that if the Dollar re-rated rapidly lower (essentially a devaluation) that US exporters would see the equivalent benefit (which was what we saw with Brexit and FTSE of course).  The other inputs here are of course the “steroid shot” of both the tax cuts on consumption / demand, the potential for de-regulation, and of course the GDP-kicker that is a massive deficit-spending infrastructure build program.  Other views are too that if bonds were to rally on “risk off” that it makes sense to sell it (especially with the growthy / inflation-inducing policy to come), while others thought that any USD kneejerk lower should also be bot on account of longer-term potential repatriation of overseas corporate cash (part of Trump platform during election), as well as potential for big data looking a year out under the regime.  That said, all were in agreement as to the eventual very bad hangover to follow from this debt binge while cutting tax receipts and not touching entitlements.


So outside of this feedback exercise….what is always a trade of interest to me is a ‘risk reversal’ or generally asymmetrical ‘skew buying power’ trade with stock index (selling one 10% otm SPY put to finance a buy of almost 19 10% otm calls!!!) into an environment where there is a rush for protection…as evidenced currently by the front-end of the VIX curve inverting, with Nov over Dec now.  Add in the overall portfolio de-risking we have been seeing, high cash / low net exposures, rapidly collapsed sentiment as contrarian ‘bullish’ indicators—in conjunction with ‘positives’ like a pick-up in global growth (Manu PMIs) and earnings trajectory—and it seems like a pretty obvious set-up for a ripper of a rally following the election.
But here is where I struggle with this idea of “fitting” a further rally into Q4: I am increasingly concerned that a relief-rally following an HRC election scenario might be somewhat short-lived due to so much overhang: outstanding FBI investigations in the air and legal noise on ‘contesting the vote’…i.e. this isn’t going away.  I also think that if you look at the ‘windows’ to put on ‘pro-risk’ trades between now and year-end with the US election (and whatever follows), the Dec Fed hike determination, the Italian referendum, now the British Supreme Court “Brexit / Article 50 Appeal” et cetera, you end up with a lot of idiosyncratic event-risk for a fragile buyside psycheThe sequencing and thus the risk / reward isn’t extremely compelling attractive.  When I then add this to anecdotal feedback from many funds I speak with, who are verbalizing a desire to ‘end the year now’ and ‘protect gains’ (predominantly made in Q3 to get back into “up mid-single digits YTD”), I just don’t know how much willingness there is to chase or put on new risk.  That said, surviving and starting a new year ‘fresh’ in Q1 WOULD be a new opportunity to pivot more ‘risk proactive’ again. 


One observer at a macro dinner I participated in last night stated that although he understood this view on “Q4 rally reticence,” he also thought that that same Q3 performance claw-back which got many funds back to “up lower to mid-single digits” YTD has now seen a couple percent shaved off of that with the friction “getting out” over the past week.  As such, this person believed that funds sitting near zero then WOULD BE candidates to prep for performance chase into this “seasonality / buyback resumption / election relief / under-positioning / over-bearishness” rally scenario. 


It’s all food for thought.

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