My Comments: There are many comments from presumably smart people at the end of this article that appeared recently. You can find them via the link just below. Many refute what he says and think he’s full of it.

Meanwhile, I’m a retired person, and the threat of losing too much money in the short-term weighs heavily on my psyche. I have little new income to add to my comfort level as the years pass. Which means that I’m still sitting about 50% in cash and doing my best to be optimistic while at the same time worrying I’ll miss a huge recovery.

by Mott Capital Management /16 JUL 2023/ https://tinyurl.com/mr2s9aku

The stock market has seemed to defy expectations in 2023, myself included. I have been quite bearish on the market for good reasons. I have learned over the nearly 30 years I have been following the market, going back to my internship days in the late 1990s through my buy-side trading days as a domestic and international equity trader at a multi-billion long-short asset manager before, during, and after the great financial crisis and more recently working for myself, that when something doesn’t make sense in the market, there is a good reason, and that one should take extreme caution.

That doesn’t have to mean that one should be short the market. Simply raising cash and sticking with the highest quality long-holdings may suffice, which is how I currently position myself. After all, this has been one of the most aggressive, if not the most aggressive, Fed rate hiking cycles in decades, which has led to 500 bps of rate hikes in about a year. On top of that, many investors and analysts have made calls multiple times that the Fed would be done as far back as March, but the Fed is not done, and at least one more rate hike in July appears to be on the way, and probably another in the fall, which creates even more risk.

If one had looked back in December 2021 and said that the Fed would raise rates 500 bps and that the 10-Yr actual real yield would go from -1.2% to 1.6% in just about 18 months, and that the S&P 500 would be down just a mere 6%, one would laugh.

Things seemed to be operating instead normally until the middle of March when the S&P 500 was trading around 3,800, and flirting with much lower levels, as real rates were on the cusp of exploding higher following Jay Powell’s testimony to Congress that more rate hikes would be needed to bring inflation back down to the Fed’s 2% target.

Things Changed Around SVB

But then something changed, and SVB failed; rates fell dramatically for a time, allowing financial conditions to ease and helping stocks to rise. But something else also happened because earnings suddenly came in better than feared. The easing of financial conditions seemed to ease investors’ minds that a recession would be delayed, and this helped financial condition eased more.

But what has ensued has become what I think is the most ultimately, in the most basic form, a bull trap, explained another way I feel is the ultimate gamma squeeze. We saw gamma squeezes in low-quality names in 2021, like FUBO, Lemonade, or Roku. Many people laughed, said I didn’t understand the market, or was simply wrong.

The Squeeze

We are now seeing something similar develop but on a much larger scale. Today’s move higher in the market appears to be nothing more than a trade, where investors are selling implied volatility in the S&P 500 and then hedging that risk either by buying out of the money implied volatility hedges or dispersing that short volatility risk into a basket of S&P 500 stocks. This has a mechanical function that pushes stock prices higher, pushing the S&P 500 higher and pushing implied volatility for the S&P 500 down. The problem is that once this pops, it will be deflated, and given how out of whack market valuations are, there will be very little to support the market when it reverses.

This is very easy to see to some degree; it started in mid-March and is visible when the 30-day implied volatility for an at-the-money S&P 500 options started falling, while the 30-day implied volatility for similar options began to rise for Meta (META), Alphabet (GOOGL) (GOOG), and Amazon (AMZN).

Typically, when implied volatility is rising, a stock price will fall, but in this case, the stock prices were actually rising. When a stock price starts to increase, and the implied volatility of that stock price starts to rise, that is the first warning sign that what is beginning is a gamma squeeze, or when investors start grabbing to buy call options.

The confirmation tends to be when the stock price rises, implied volatility increases and the SKEW falls. This happened as the implied volatility for Meta’s one-month 110% option was rising faster than the one month’s 90% indicated volatility option was rising. In this case, the demand was to own the calls over the puts.

This was also the case for Amazon and the case of Alphabet. As implied volatility rose, the SKEW fell, again indicating a grab for traders to own the calls.

This trade has continued for months now rotating, and, since the beginning of June, this trade has spread to the top 7 stocks in the S&P 500; as the implied volatility for Apple, Microsoft, Amazon, Alphabet, Tesla, Meta, and Nvidia is generally rising at this moment, the implied volatility of the S&P 500 falls. It is tough to pinpoint an exact moment, but this happened around the beginning of June.

Additionally, we have seen the SKEW index rise dramatically over the past several weeks as investors seek to hedge against tail risk, of course, as the VIX index drops sharply, which also started around the middle of March.

A Short Volatility Trade

So again, the current move in the equity market appears to be nothing more than a short volatility trade or, in other terms, a short volatility dispersion trade. I believe it means selling index volatile, buying index component volatility, and hedging the trade by buying the index components stocks. It appears to also potentially involve buying out of the money index implied volatility too. Of course, the options dealers need to hedge all of these as well, and in essence, I believe it creates a gamma squeeze or a trade that forces option dealers to buy the underlying stock, and the higher the stock price goes, the more of that stock that needs to be purchased to remain hedged.

SVB created a unique opportunity for this to develop because, following SVB, the Fed eased up on financial conditions by allowing its balance sheet to expand; this easing of financial conditions allowed implied volatility to begin to come down, allowing this trade to take root. Additionally, interest rates and the dollar fell sharply, also contributing to easing financial conditions. The easing of financial conditions allowed implied volatility to fall and equity prices to rise.

I believe this is why rising rates have not affected stocks in recent weeks, as I expected, because despite rates rising, financial conditions have actually continued to ease. And as long as financial conditions stay loose or ease further and index implied volatility is pushed lower, this trade can continue to work.

However, if financial conditions should begin to tighten, ultimately, implied volatility on the S&P 500 will begin to rise, which will start a pretty nasty unwinding process. Additionally, earnings seasons create another risk to this trade.

This week may allow for such an event to happen because on Wednesday, there will be a VIX options expiration, and on Friday, there will be a stock market options expiration. This will release a lot of positive gamma from the market, which is a condition that can create a rise in volatility as the cushion from a positive gamma environment evaporates.

I do not believe this is the environment that many investors believe it to be; this appears to be one large short-volatility dispersion trade, and when this trade is unwound, I believe this will be an excruciating process because there are no fundamentals in this market to support current valuations. Stocks are worth a lot less, based on PE ratios and even relative to bonds.

Be careful out there.