December 6th, 2023 | "Neutral Gamma"

Big is beautiful once again as the rotation seems to have drawn to a close. Mega-caps dominated the overall market return as a neutral S&P was composed of 80% decliners. Remarkable.

Short-dated vol retreated and now sits back on the cusp of single digits. Friday's NFP is the start of a series of data points that culminates with the last Fed meeting of 2023. The vol surface reflects this. Beyond that point, it's smooth sailing into year end.

The rally in rates has driven mortgages to a multi-month low. Predictably, mortgage activity has rebounded as mortgages entered at higher rates have now surpassed the 50bps threshold to make refinancing economical. Unfortunately, purchase applications barely budged, suggesting the appetite for buying has waned.

ADP data is also out ... unsurprisingly it was disappointing. And we hope you're sitting down, because you might be surprised to learn prior reports were ... revised lower.

Gamma Exposure:

Market makers have returned to neutral gamma, indicating that dealers are balanced at current levels. This implies that small variations in the underlying asset (specifically, SPX Futures) will not significantly affect the delta of the contracts, leading to comparatively modest hedging flows on small changes in asset prices.

Rather than suppressing volatility as seen in a long gamma regime, the neutral state means these funds will have less influence on the market in either direction. A move upward returns us to positive gamma; lower, we may finally get some drama. But let's be real ... ain't nobody got time for that.

The risk from here lies below the 4550 strike, where dealers will broadly be pushed back into a short-gamma regime. If that happens, we expect to see realized volatility levels pick up again, potentially triggering a market retraction as systematic funds are forced to reduce their exposure again. If SPX can stay above the gamma flipping line, then we suspect the current consolation phase will continue until further notice.

Probable Volatility Bands:

SPX is still floating in the middle of the PV range. We will be disciplined to the range for the next few days, especially with NFP on Friday. We suspect that 4600 holds and moves the index down to the lower band at 4532 in the very short term.

NDX bands are now orientated down very slightly. The top of the range is still above 16200 with the lower band now 15715.

The bands worked as intended for Russell yesterday and are now bouncing off the 1850 strike. Today's upper range is 1885, and the lower band sits at 1821. Still bearish trend.

S&P 500 Market Breadth:

Our MBAD indicator was heavily skewed toward the downside yesterday, with around 82% of the index closing in the red. Of those stocks declining, the average return was also quite large at -1.3%, which implies the sell-off wasn't just widespread but quite significant in size as well. Overall, there was quite a bit of volatility happening beneath the surface, although we suspect most investors completely missed this action by taking the spot price at face level.

Despite the weakness, the VIX actually saw a decline of -1.8% even though the broader market was in a sell-off mode. From our perspective, vol was extremely mispriced yesterday, while the mega-caps heavily distorted the cash index keeping it unchanged. By the close, just ten companies were able to cancel out the negative returns of 409 stocks, masking the bulk of the decline. For reference, the RSP equal weight SPX was down -0.9%, which we believe is a more accurate representation of the day.

Being aware of these nuances is exactly why we spend so much time focusing on market breadth and index construction since the spot isn't always what it seems. We've seen this play out time and time again in 2023, where the mega caps are responsible for a majority of the year-to-date gains while the broader maker has significantly lagged behind. So much for passive indexation offering a "diversified" basket of stocks.

Quant Fund Implied Rebalancing:

Despite the weak breadth, realized volatility was relatively unchanged yesterday, with the one-month vol still trading in the high 9s, and the three-month volatility in the high 12s. Remember, vol control funds typically deploy a strategy called volatility scaling, using the higher of either the 1-month or 3-month volatiles as the main toggle for equity exposure.

Given the wide spread between these two vol windows, we suspect the 3-month vol will continue to play a key role in guiding risk exposure for volatility control strategies for the foreseeable future.

This is an important detail because, by design, we tend to see smaller rebalancing flows when the 3-month vol is higher, which in turn means vol control funds will have less of an impact on the equities market. This broadly explains why vol control funds have been so inactive for the past several weeks, as these strategies have mechanically adjusted for a lower-vol regime.

When deployed, risk-targeting strategies really can offer a less volatility equity curve, although it usually comes at the cost of some excess returns. While this might not be the best strategy for generating alpha, risk-targeting strategies are a popular choice by more conservative funds in the insurance sector, which require consistent liquidity in diverse market conditions and aim to avoid the expense associated with premium depletion from Put protection.

For today, we suspect these funds will remain largely inactive unless we start to breach a return window of +/- 2%. Since dealer flows still favor a lower vol regime, we're not expecting these thresholds to be hit today.

Bonus Chart:

Today’s bonus chart deals with the Fed’s policymaking in reaction to their second mandate of full employment.

Last week’s continued unemployment claims data climbed to 1.9 million. Additionally, in yesterday’s JOLTS data, we saw openings for October drop to 8.73 million, which is the lowest since May of 2021 — the ratio of openings to unemployed workers is 1.3 vs. 1.5 prior. For reference, 1.2 was the ratio pre-pandemic. Prior month, JOLTS were revised lower to 9.3 million as well.

Danielle DiMartino Booth has wisely pointed out that 50 states have higher unemployment year-over-year. Texas is the notable exception. Going back to 1976, when we've seen 50 states with higher unemployment, nine out of nine times, it led to subsequently disappointing NFP reports. With 2023 the year of the negative revision, it may require more time than usual to recognize this slowdown.

Today’s chart implies that Jay Powell will need to cut as early as Q1 of 2024.

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