Hertz so bad

The tug-of-war between optimism and fear.

I guess it boils down to which train you're willing to get hit by.

Markets consolated over the last few weeks after being pelted with a bewildering array of headlines. There are two competing narratives in the market; the first focuses on increasing case counts while the second concentrates on the prospect of a further stimulus (on the fiscal and monetary side). Both have their associated risks. The critical question, as it relates to COVID-19, is how much COVID is too much COVID? In other words, when will increasing infection rates stop reopening plans. Meanwhile, the prospect of further stimulus is mainly dependent on the economic outlook. Data continues to suggest that the worse is behind us, and many market participants have flagged concerns that policymakers (on the fiscal side mainly) will take their foot off the gas. That suggests that, for markets to remain constructive, we're going to need a delicate balance of enough COVID cases to slow the economic recovery while at the same time allowing for economies to reopen. If that sounds ridiculous, it's because it probably is. If COVID-19 doesn't dampen sentiment, policymakers eventually will.

There is increasing evidence of a nascent second wave.

COVID-19 related headlines caused considerable consternation among market participants this week as pockets of the virus have appeared in highly populated areas. In China, Beijing went back into lockdown after an outbreak in the city's most abundant food and vegetable supply center. Since then, Beijing claims to have contained the virus, but naturally, many are skeptical. In the US, things look even less reassuring. Weeks of protests have allowed the infection to spread, and we're beginning to see this in the income data. Daily case counts are well above their 7-day moving average, and footage of President Trump's rally in Tulsa Oaklahoma made it pretty clear supporters are not interested in social distancing. Six of President Trump's staffers in Tulsa tested positive for the virus during a routine screening, making for foreboding headlines. In a sign of what's to come, Apple closed 11 stores across four states in what the company calls "an abundance of caution." Markets were not enamored with the news. The chart below shows daily case counts for both the US and globally. Note that neither is declining.

If the pandemic wasn't enough, Kim Jong Un has you covered.

Amongst all the headlines, Pyongyang managed to blow up an inter-Korean liaison office, which, surprisingly, was somehow expected. The destruction of the liaison office, which was described as a "terrific explosion," is largely meaningless, but I can't imagine this is "good" for Korean relations. A potentially more worrisome development on the geopolitical front came from the death of 20 soldiers in a border clash with India and China. The fact that I am mentioning India-China relations is probably enough to tell you that things are not great. Between these developments, the latest Presidential scandals with John Bolton's book, and the firing of the SDNY Berman this weekend, markets have plenty of content to be skittish. Yet they aren't, at least not yet. If anything, last week served to highlight how geopolitics' ability to impact markets has been severely impaired. That's the uncomfortable reality of modern markets that are driven by stimulus rather than fundamentals.

Stimulus > COVID for now

It's all fun and gains.

There were two critical developments on the stimulus front, which kept markets buoyant over the week. On Monday, the Federal Reserve announced that it would begin buying individual corporate bonds, which reinforced the notion that the Fed would continue to put a floor on asset prices. The second came from news that the US administration was drafting a nearly US$ 1 trillion infrastructure plan. Although the program remains very preliminary, markets took the story in stride. Of course, the reality is that we have plenty of fiscal cliffs coming up in the coming weeks. Almost all of the programs associated with the US$ 2.3 trillion CARES package will be out of money by the end of July, and Congress will need to renew/extend those programs. Jerome Powell's testimony to Congress last week made it very clear that removing fiscal stimulus while the recovery is in its infancy is a recipe for disaster. For the time being, many expect the programs to be extended without any issues. The greater concern is that, as (if) the outlook improves, policymakers will be less willing to continue these programs. That will be the real threat to markets going forward. The reality is, the stimulus has been the main driver in markets, which has drastically removed the likelihood of a market crash. The chart below shows a simple volatility model on the S&P500. The black line indicates the left tail of the return distribution each day. We can see that the distribution has somewhat normalized.

Picking stocks out of a scrabble bag.

The latest red dot in the chart above was from two Thursdays ago, where retail traders were taken to the cleaners. I put together a basket of the top 20 most popular stocks on Robinhood and found that that basket was down an astonishing 20 percent two weeks ago. I wrote a separate post about this, which can be found here for those interested. Now, I mention this because the financial media has been somewhat obsessing over retail investors who have been piling into bankrupt companies. One company that has garnered the most press has been Hertz, particularly due to its highly dubious plan to issue more shares after filing for bankruptcy. Let's not sugarcoat this; this is one of the most ludicrous stories in recent market history. Hertz is woefully mismanaged for those unappraised, having gone through five CEOs in the last six years. That is not the staple of a good company. The chart below is from Robintrack and shows how retail has piled into Hertz stock after the company filed for bankruptcy. Again, I was hesitant to cover this because it's completely irrational. For those wondering, the SEC has stopped Hertz from issuing additional worthless stock. I guess someone has to save retail investors from themselves.

Source: Robintrack

Is retail driving the broader market?

My take on the above is that it's a great story, but there is no way retail trading drives aggregate changes in the broader market. There aren't enough assets under management, if that's the right word, for their flows to matter. Bloomberg estimates that retail trading accounts for about 1 percent of the entire market; that's peanuts. With that said, retail can impact price in small-cap stocks (and bankrupt ones for that matter). Any market that isn't liquid enough for the institutional money to invest can be influenced by retail exuberance.

Equity positioning remains low.

Any prospect of a continued rally in equity markets rests solely on the hope that positioning among institutional investors remains low. The only investor types that have somewhat participated in the recent rally have been CTAs, or momentum investors, which are around 25 percent invested according to the latest estimates from JP Morgan. The idea is that, as long as volatility remains reasonably stable, and there are no new macro-shocks, systematic investing strategies will eventually begin to increase exposure. From there, the fear of missing out (FOMO) will catch wind, and discretionary investors will start to participate. Indeed, some of the more volatile periods of March have begun to fall out of the 3-month lookback window, and volatility control funds have been increasing their allocation. The chart below shows the estimated buying each day last week for each lookback window.

Dealer gamma is close to flipping short.

After what was a massive option expiry, dealers have drifted closer to the dreaded gamma flip zone. Remember that when dealers have positive gamma, they tend to suppress volatility, while dealers with negative gamma are adding to volatility. The chart below is a smoothened version of the bar chart I usually produce, shows that the gamma flip is roughly where the spot market closed on Friday (the red line). Any market strength going into the week will likely be met with selling from market makers, which should help keep volatility low, prompting more buying from volatility control funds. Of course, the opposite is also true. Should we see a sharp move lower, dealers will likely exacerbating volatility. Futures are currently pointing a touch stronger.

Thanks for reading,

Tiago Figueiredo