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Maybe They Do Care

By:

Chief Strategist at Interactive Brokers

Yesterday we asserted that market psychology has morphed from bullish to nihilistic.  Little seemed to matter to investors as long as there was a trend to ride higher.  News that ran counter to the prevailing narrative of higher asset prices could be conveniently ignored and any negative reaction was simply an opportunity to buy a dip. 

The initial response to yesterday’s 2:00 PM (EDT) release of the minutes of the Federal Reserve’s Open Market Committee (FOMC) July meeting seemed to prove that point.  Consider the chart below, particularly in the 13:00-14:00 period (the chart below shows times in CDT, not EDT)

SPX Index Intraday, August 18, 2021

SPX Index Intraday, August 18, 2021

Source: Interactive Brokers

We see the usual pattern.  A quick selloff on the news, then a quick recovery once traders bought the dip.  But this was not the sort of item that could be shrugged off quickly.  The FOMC minutes noted that the Fed’s inflation target was largely met, and the discussion among members appeared to be about how soon to begin tapering asset purchases, not whether the policy was appropriate. 

Monetary stimulus on an unprecedented scale has been a backbone of market psychology for most of the past decade, and especially during the past year and a half.  It has contributed greatly to investor nihilism.  Why worry about pesky problems that might affect earnings, the economy or geopolitical stability when the Fed has your back, pumping money into the system no matter what?  Here was the Fed, literally discussing how quickly they might abate their record stimulus, and investors continued to seem blithely unconcerned.  For better or worse, at least some traders noted that paradox, and the market reacted accordingly:

SPX 2 Day Chart – August 18 – 19, 2021

SPX 2 Day Chart – August 18 - 19, 2021

Source: Interactive Brokers

The market sold off dramatically during the final two hours of the trading day, finishing about 1% lower, with the selloff continuing in overnight trading.  The abrupt turnaround this morning has proven to be yet another in a long series of buy-the-dip opportunities for traders, but I believe that tomorrow’s monthly options expiration also has much to do with the activity.  The recent quiet markets and low volatility emboldened options writers and left many traders long expiring options that were decaying quickly.  The late drop yesterday undoubtedly spooked some traders who were short gamma, causing them to sell into yesterday’s decline.  Today’s bounce must have incentivized long options holders to hedge by buying at this morning’s lower levels.  For example, the open interest in the expiring SPX 4400 strike was over 20,000 in both calls and puts.  Considering that those options are traded mostly by professionals who tend to actively hedge, that created a significant incentive and opportunity for those who were long.

(It is crucially important to remember the nature of long vs. short gamma trading.  Moves in underlying stocks cause the delta of options to change.  A down move decreases the options delta while an up move increases it.  That effect is more pronounced in the closer an option is to its strike and expiration, particularly if the underlying stock crosses through strikes.  Traders who are long gamma are incentivized to hedge by buying low and selling high.  Those who are short gamma are incentivized to do the opposite.)

Before we get too carried away with investors seeming to suddenly become concerned with a potential change to monetary policy, we need to look at the longer-term trends in the market.  Two declines totaling under 1.5% do not mark a trend reversal.  It is quite apparent in the chart below:

SPX – 2 Year Daily Chart with 50 (blue), 100 (red), 200 (purple) day Moving Averages

 2 Year Daily Chart with 50 (blue), 100 (red), 200 (purple) day Moving Averages

Source: Interactive Brokers

Today’s opening drop took us only to the 50-day moving average that has provided support at various points during the current move.  Traders often base their decisions on whether moving averages are rising or falling.  During uptrends, they buy dips, especially when the moving average in question has been supportive.  It is impossible to argue that the longer-term moving averages are presently displaying anything other than steady uptrends.  Like it or not, it is a technical setup that argues for buying dips, not selling rallies right now – at least in SPX.

Before we give an all-clear to nihilism, however, we should point out that SPX is on much more solid footing than one of its peers.  Consider the Russell 2000, represented below by the IWM ETF:

IWM – 2 Year Daily Chart with 50 (blue), 100 (red), 200 (purple) day Moving Averages

2 Year Daily Chart with 50 (blue), 100 (red), 200 (purple) day Moving Averages

Source: Interactive Brokers

The moving averages show a much different picture.  The recent sideways movement has caused the 50 and 100-day averages to flatten and even turn slightly lower.  The current test of the 200-day might indicate that even that trend is threatened.  Investors appear concerned about the pace of economic activity affecting smaller, more sensitive companies, even if they display almost no concern in their larger brethren.

Perhaps investors need to be more selectively nihilist…

Disclosure: Interactive Brokers

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The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers LLC, its affiliates, or its employees.

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