Physik Invest’s Daily Brief is read by thousands of subscribers. You, too, can join this community to learn about the fundamental and technical drivers of markets.
Administrative
For the first time in a while, I am able to catch up to and focus more on active trading, hence the earlier letter, today. What a crazy past few months. Almost back to normal!
We will issue a content calendar, soon, revealing the dates letters are likely to be published and the content that may be covered.
That said, due to the writer’s travel commitments, from 12/6 to 12/9 and 12/12 to 12/16 there will be no commentaries. If any queries, or if you are local to New York City or Paris, ping renato@physikinvest.com or Renato Capelj#8625 on Discord.
Fundamental
In many ways, the opposite of what happened to bolster a rally across risk assets like equities and crypto is happening, now. As unpacked in detail across letters including our Daily Brief for October 5, 2022, liquidity measures are in a near-lockstep fall with the S&P 500 (INDEX: SPX).
The correlation between so-called net liquidity described further below, and the S&P 500, over the past ten years is about 0.70 and explains more than half of the movement in price-earings multiples over the past decade.
Detailed in previous letters was how processes like quantitative tightening manifest themselves as less demand for assets; per Fabian Wintersberger, central bankers must “recycle bonds into the markets on an unprecedented scale, which could easily lead to lower bond prices/higher yields” causing a “reflux of capital to safe-haven assets, like treasuries.”
Alfonso Peccatiello of The Macro Compass details more on the impact of more or less financial sector money in a post titled “All They Told You About Money Printing Is Really, Really Wrong.”
Adding, “the Fed has [only] reduced its holdings by 1.5% by letting bonds mature on its balance sheet. If they want to reduce the balance sheet back to the level of 2020, it needs to reduce it by 41%; … [therefore], [i]f history is any guide, the stock market has yet to face its most significant problems in such a scenario.”
Morgan Stanley’s (NYSE: MS) trading team agrees, per a recent Bloomberg article on a looming bear case for the S&P 500.
Though “rate increases get all the blame for this year’s bear market” and a projected “slowdown in the pace of rate hikes” helping “equities emerge from the yearlong bear, … the S&P 500 will drop as much as 15% by March, based on historic patterns and projected money flows,” which major inputs include “changes in the Fed’s balance sheet (BS); the Treasury General Account (TGA), or Treasury cash held at the central bank; and Reverse Repo Facilities (RRP), or cash parked at the Fed by money market funds and others.”
In other words, net liquidity is the Fed’s BS less TGA and RRP. See the below graphic.
Accordingly, “a rise in Fed’s balance sheet means an expansion in liquidity that bodes well for stocks, while an increase in TGA or RRP suggests a contraction in liquidity.”
Based on the QT pace ($95 billion per month) and forecasts the Treasury cash balance will “rise by $200 billion into yearend, … [amounting] to a squeezing of liquidity that alone implies an 8% drop for the S&P 500 by the end of December.”
In summary, “there’s no longer enough money to finance [the] production of those goods and to support a stock market that’s still far from cheap.”
Positioning
As we said earlier this week (November 29, 2022, and November 28, 2022), it’s not a terrible time to hedge, and selling volatility, blindly, on either side of the market, is not a great trade.
As SpotGamma put well, yesterday, implied volatility (IVOL) is at a low meaning “it makes sense to buy volatility and put on trades that make money if the market moves” but leverage the skew to sell “options to cut down the cost of waiting for that movement to happen.”
In our letter, yesterday, we highlighted Nasdaq 100 (INDEX: NDX) volatility skew and showed it was smile-shaped, rather than the typical smirk-shaped reverse pattern, making for some great trades to the upside. Through steeper call volatility skew – a result of traders positioning for an upside move – we can use the richness of further away calls to reduce the cost of our bets on the market upside.
For instance, low-cost 500-1000 points wide call ratio spreads (buy the closer leg, sell two of the farther legs) expiring in fifteen days may work well (e.g., SELL -1 1/2 BACKRATIO NDX 100 16 DEC 22 [AM] 13425/13925 CALL @.20 CR LMT). The immediate concern with these strategies is your exposure to Delta (i.e., direction) and Gamma (i.e., does movement make you money).
The required reading is Dynamic Hedging: Managing Vanilla and Exotic Options!
If you are exposed to +Delta and +Gamma, your trade makes money in an increasing way as the market rises, barring any other changes (e.g., passage of time, increases in volatility, etc).
If you are exposed to -Delta and -Gamma, your trade loses money in an increasing way as the market rises, barring any other changes. Should the movement happen quickly, and volatility rise, which is not likely, then that worsens the situation.
The required reading is Dynamic Hedging: Managing Vanilla and Exotic Options!
This is not advice but a framework for how to act on the theory we talk about on a daily basis. In short, don’t sell calls and puts blindly. Adding, the above trade may not provide safe exposure to the market upside or downside. Given the sideways trade and contraction in ranges, we aim to be well-positioned for a move from low to high volatility. Stay safe and watch your risk.
Noting, should you sell IVOL, the market trade lower, and the demand for IVOL rises, you may be left in an awkward position; big market drops statistically add to the likelihood of more drops.
Read The Second Leg Down: Strategies for Profiting after a Market Sell-Off!
Technical
As of 7:15 AM ET, Wednesday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the upper part of a positively skewed overnight inventory, inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.
Our S&P 500 pivot for today is $3,965.25.
Key levels to the upside include $3,997.00, $4,024.00, and $4,051.00.
Key levels to the downside include $3,923.00, $3,909.25, and $3,871.25.
Click here to load today’s key levels into the web-based TradingView platform. All levels are derived using the 65-minute timeframe. New links are produced, daily.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for long periods of time, it will be identified by low-volume areas (LVNodes). LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to HVNodes for favorable entry or exit.
Gamma: The sensitivity of an option’s Delta to changes in the underlying asset’s price.
Volga: The sensitivity of an option’s Vega to changes in the underlying’s implied volatility.
POCs: Denote areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future tests of value as they offer favorable entry and exit.
MCPOCs: Denote areas where two-sided trade was most prevalent over numerous sessions. Participants will respond to future tests of value as they offer favorable entry and exit.
Volume-Weighted Average Prices (VWAPs): A metric highly regarded by chief investment officers, among other participants, for quality of trade. Additionally, liquidity algorithms are benchmarked and programmed to buy and sell around VWAPs.
About
In short, an economics graduate working in finance and journalism.
Capelj spends most of his time as the founder of Physik Invest through which he invests and publishes daily analyses to subscribers, some of whom represent well-known institutions.
Separately, Capelj is an equity options analyst at SpotGamma and an accredited journalist interviewing global leaders in business, government, and finance.
Past works include conversations with investor Kevin O’Leary, ARK Invest’s Catherine Wood, FTX’s Sam Bankman-Fried, Lithuania’s Minister of Economy and Innovation Aušrinė Armonaitė, former Cisco chairman and CEO John Chambers, and persons at the Clinton Global Initiative.
Contact
Direct queries to renato@physikinvest.com or Renato Capelj#8625 on Discord.
Disclaimer
Do not construe this newsletter as advice. All content is for informational purposes.
Physik Invest 