Fears of a Pandemic, US Economic Slowdown, Weakening China, and Lower Oil Prices
• Options Activity: On Friday, spot fell below zero gamma ($SPX model) making the market vulnerable to markedly increased volatility. 3200 represents a key level, still functioning as a “put floor” (support). 3250 plays the role of “call ceiling” (resistance). Several prior tweets have looked at this, in detail.
Last week was the third week in a row that exceeded the implied move, priced by the 7-day Weeklys. The current expected move is widely expanded, owing to an increase in uncertainty surrounding coronavirus contagion and a PMI that hit a 5-year low.
• Valuations: Calls remain relatively underpriced and OTM puts continue to get a bid. Dark pools data shows no evidence of significant selling.
• Volatility: VIX futures saw an inversion in term structure. That is, volatility strategies have increased weighting in the front month to the point of backwardation. VIX futures rose to a high of 16.5 Friday. Volatility of volatility is elevated and, on Friday, touched the critical 16 level.
• Auction Market Process: A down-auction and range extension to a low of 3215.25 on Friday. Rotation in S&P futures overnight to an auction bracket high of 3250. 3250 is the level to watch for rejection in an up-auction. Continued liquidation at that level would signal sellers in full control.
• Bonds: Signaling an end to the “reflation trade.” (The term “reflation trade” refers to structural conditions wherein interest rates are expected to rise a small amount and the odds of recession are widely considered to be quite low.) The yield curve for the 10-year has fallen to a level below the 3-month, marking an inversion. In essence, bonds are underpinned by yields and policy inflection points. The Fed has stated they will let inflation run, institutionalizing lower rates via inflation averaging.
The selloff in Junk bonds has deepened further, owing to fears of a pandemic, economic slowdown, and lower oil prices.
• Macro: Elevated asset prices and weakening economic conditions are becoming increasingly unsustainable. International exposure, while more attractively valued, is much less resilient to global economic weakness.
• Calendar: Economic Announcements: Construction Spending, Auto Sales, ISM Manufacturing. Earnings GOOGL, after the bell.
While the market has been treating the coronavirus health scare as a “one off event,” fears are mounting that continued spread will expose other microstructural weaknesses and will, thus, have lasting effects on the market. The coronavirus outbreak amplifies two vulnerabilities: structurally weak economic growth and Federal Reserve policy impotence. Add to these an exacerbation of trade tensions, a growing awareness of the economic impact of climate change, political polarization and geopolitical risk, and changing demographics.
The viral outbreak is a major economic shock and the negative economic effects are not sufficiently absorbed by the markets. Collectively, these weaknesses should decondition those who approach selloffs as an opportunity to “buy the dip”.
Now is the time to give great attention to vulnerabilities in one’s portfolio with respect to equity exposure and liquidity risk.