Many of you know that I am a big fan of market adages. In fact, I’ve recently taped an IBKR Podcast about the topic. Even some of the silliest sayings contain time-tested market truths at their root. We certainly see that in phrases like “the trend is your friend,” “buy low, sell high” and the like. But one of my favorites has recently been turned upside down, and I believe that the “product du jour” is the reason.
Consider the phrase “stocks take the stairs up and the elevator down.” Throughout history we have seen equity markets rise steadily over time in major bull market uptrends, and then give back large portions of those gains in panicky down moves. But lately we have seen the opposite.
From August through October we saw stocks grind lower without major downdrafts and without substantial increases in volatility (or demand for volatility protection). The selloff was generally orderly. Remember, even though VIX rose from the mid-teens to the low twenties, that is hardly the sort of move that indicates true fear. At least recently, stocks generally took the down staircase, not the elevator.
Yet recently we have seen stocks take the up elevator. During the 10 trading days in November prior to today, we have seen three sessions where the S&P 500 (SPX) rose more than 1.5% – including last Friday and Tuesday. The NASDAQ 100 (NDX) had four. The moves definitely did not occur in a vacuum. Both bonds and stocks had become deeply oversold in recent weeks, so they reacted very positively to signs that inflation is ebbing and that the labor market is easing. As we noted yesterday, the market has priced out the idea of further rate hikes from the Federal Reserve and has become more aggressive about pricing in cuts next year. (I agree that there is virtually no probability of an imminent hike but believe that the market is too enthusiastic about rate cuts.) Those indeed are good reasons for rallies in both stocks and bonds.
The nature of the most recent rallies, particularly Friday’s, got me thinking about the stairs/elevator adage. As it was occurring, we noted that Friday’s rally had the same character as the “gamma squeezes” that we came to expect on many Fridays during the 2020-2021 bull market. Remember, all sorts of traders discovered the power of options trading, particularly because they offer the possibility for leveraged speculation with defined risk. Furthermore, they realized that enough traders crowd onto one side of a trade, it improved the odds of it becoming self-fulfilling. On a bullish day, if traders buy sufficient quantities of slightly out of the money expiring options, those who sold them the options find themselves needing to cover their delta exposure as the stocks rose (i.e. gamma). At its most extreme, it can create a somewhat self-sustaining feedback loop. And with the advent of daily expirations (aka 0DTE options), traders don’t need to wait for Fridays to attempt this strategy – though it is more effective when hundreds of popular equity options join the usual cadre of index and ETF options.
Statistics bear this out somewhat. Over the past six months, which have seen significant ups and downs in the market, SPX rose on 53% of the 128 trading sessions. That is a historically typical percentage. On up days, SPX rose by +0.65%, while on down days it fell by -0.60%. In recent history, we have actually seen more aggressive buying than selling, though only modestly so (and with too small a timeframe to be statistically significant).
Why might this be? We noted the reasons why modest rallies sometimes metastasize into major ones. But the same doesn’t hold true for down days. The feedback loop could easily occur on the downside, but it rarely does. I believe this is because most traders are more comfortable trading from the long side than the short.
Now, all this goes out the window if traders get nervous, let alone panicky. Then we see aggressive sellers and timid buyers, which leads to the “down elevator.” But even during the recent downdraft, that situation didn’t occur. It hasn’t since March, when banks failed, but the quick resolution of that crisis led to willing buyers even as markets fell this autumn. And now that we are in a bullish cycle, those buyers have become aggressive once again. Don’t be surprised to see more “up elevator” days while the mood remains sanguine.
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We are reaching the closing days of the year, and professional traders (and pundits) are often graded on their yearly returns. Now I think that this type of assessment is artificial for those who don’t need to access our capital on an immediate basis, it is quite different for those whose jobs are at risk from their perceived grade. So for professionals who espouse the tenet of good diversification, comparison to the Magnificent Seven will cause them to shrink this year. Hence it isn’t surprising to see an elevator up at this time, as they pile into the winners not just in the hope of increasing their percentage gain, but also in showing that they held the “winners”.
When this phenomenon occurs it is not uncommon for it to lead to a down draft after the new year. Sometimes the drawdown is somewhat delayed due to fresh money coming in in January, but I would guess we would see it long before tax time. Btw, as I said above, I think that a short term focus on return is detrimental for one’s emotional or financial health. To me it is better to look at five year rate of returns or for the less experienced three year. If your progress over the longer term is better than the alternative, then there is less reason to fret.
The rally in both bonds and equities started on Oct 30th, the date that Treasury department announced borrowing targets. They reduced long duration bond offerings and increased short duration bond offerings. This caused long bonds to rally from oversold levels, and triggered a bull run in equities as well. From there on, we’ve seen higher demands for the 10 year, (30 year auction was a bust, but apparently due to ICBC being hacked).