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More Gamma Notes From Tier1 Alpha-25Aug, 2022

A learning moment from a young man in the industry making waves –

T1 Alpha Sit-Rep:
Thursday,  August 25th   Another lazy consolidation day as summer draws to a close.  Modestly worse than expected economic data combined with higher energy prices combined to deliver a slightly lower US$ which helped speculative assets like Bitcoin.  Dealer gamma remains negative, but markets were unable to move materially today leaving options to decay and modestly lift markets.  Speculative stocks were also helped by the news last night that Bed Bath & Beyond (BBBY) was shopping a loan deal.  However, remember that this is an $800MM market cap with $1.5B in debt (and another $1.5B in operating leases) that was trading as low as 31c on the dollar for its two-year paper yesterday. No serious analysis can lead to the conclusion that this is a viable company, but hope springs eternal — as do short squeezes in our passive-dominated landscape. Against a sharp rally at start of day, we saw a quick retreat and ultimately the shares were left “unch’d.”

Unfortunately, there was very little “news” to work with given the focus on wringing out the last days of summer from the overpriced Hampton’s rental. We will see if this can persist.  As noted, dealer gamma remains negative suggesting the initial conditions are in place for a bearish reaction to Jerome Powell.      
Gamma Exposure:    
While aggregate negative gamma remains relatively muted, the 4150 strike is rapidly building and it’s reasonable to expect it to operate as a magnet the next few days ahead of the Fed’s big meeting.        
Gamma + Probable Volatility Bands:   Gamma volatility and PV bands both showed evidence of the recent downturn with the slopes of both bands turning sharply lower.  The data would suggest protection buying remains relatively elevated which leaves us in both dangerous territory and relatively unconcerned about a major “financial system” blow up; an active land-war and energy crisis in Europe makes a Nasdaq crash look like a stroll in the park    
As we noted on Tuesday, one path to improved risk/rewards was simply a modest consolidation and today saw that plan largely put into action.  Risk/rewards for the largest stocks have improved markedly from Monday’s session.          
There has been little to distinguish between the major axis, as the Nasdaq looks almost identical to the S&P500.  Within sectors, we are largely sitting at 50/50 risk/reward — a dramatic change to Tuesday’s picture.      
We can clearly see the classical widening of gamma bands for the Russell 2000 small cap ETF as rising volatility broadens the “cone of possibility.”  We continue to believe the growing exhaustion in small caps is the warning sign of the next move.      

Probable Volatility Bands:     Today we decided to split PV bands from Gamma bands.  We like emphasize that the PV bands are able to run much narrower than Gamma bands while giving up very little from a risk-range identification dynamic.  Unlike the widening gamma bands, PV bands have turned meaningfully lower suggest a change in direction unless the market reverses soon.    
We continue to highlight the cyclical small cap sector.  As we’ve expected, the initial thrust lower has been met with some sideways consolidation that now puts the RTY just inside the PV bands. With Jackson Hole only two days away, we emphasize that we are now clear for takeoff in either direction, although the bias remains lower.      

S&P 500 Market Breadth:     Our MBAD indicator was mostly neutral yesterday, with 71% of the index advancing into the close. Another low vol day ahead of the Jackson Hole conference this Friday, where Powell will hopefully share some insights on the future direction of the Fed. With dealers still broadly short gamma, the risk of rising volatility under this regime remains strong. Jackson Hole may be the catalyst we need to kick off a new trend, as volatility in either direction could trigger dealers to chase the market to balance their hedges.

 Fed fund futures are now pricing in a 60% chance of a 75bps hike in September, suggesting a significant Fed pivot is possible but unlikely.     
Although significantly down since the June lows, 57% of stocks in the Nasdaq 100 have a 1-month realized vol above 30. This is still historically high ranking in the 83%ile over the past ten years, implying volatility has been persistent in single stock tech names, even as the VXN hit a low of 25 only a week ago.      Vol Control Implied Rebalancing:    
With such a muted return, our realized vol models remained largely unchanged, triggering only a vague need to rebalance. Unless the market can produce some volatility soon, that may begin to change as both look-back windows currently sit near 5-month lows. Since our model (inspired by Nomura) tracks the higher of either the 1-month or 3-month vol, the latter remains in control of our implied rebalancing flows. This is an important point because the last volatility cluster we saw in mid-June is now sitting at the tail end of the sample, creating an inevitable opportunity for rVol to shift lower.     

Without any renewed volatility, the 3-month window is essentially sitting on a cliff, which could trigger some substantial buying requirements into the end of Q3. We are still around two weeks out from these dates making an impact, so don’t forget a lot can happen in the meantime as dealers remain deep in negative gamma.       
While we wait for those June dates to exit the sample, we’ll likely see some mild reallocations into equities, assuming the absence of further volatility. Today, those flows would be triggered between a window of +/- 1.5%.      Bonus Chart:    
It’s easy to take a chart like this and anchor on a single data point. In this case, the data broadly speaks for itself. When the monthly supply of new homes in the U.S. exceeds 8 months, historically it has been accompanied by a recession. Supply currently sits at 10.9 months.  

We want to highlight a few phenomena in the auto industry that will spill over into the housing markets in the coming months. Much to her credit Danielle DiMartino Booth, a friend of Tier 1, has been ahead of Wall Street on this. During the GFC in 2008, banks issued loans on primary residences and second homes of 120% and sometimes above on loan to value(LTV). The auto industry was relatively conservative at the time after the 2005 bankruptcy reform reduced the flow of credit to many lower-income buyers. Buyers were required to put down 10% to 20%, and LTV was restricted to 80% to 90%. When the music stopped, buyers lost their homes and kept their cars. As a result, sweeping regulations quickly corrected lending practices in the Real Estate credit markets while leaving overconfident lenders in auto loans.

Fast forward to 2022, and now we find the exact opposite dynamics. Auto lenders have issued 150% LTV loans to underqualified consumers that PPP loans and forbearance programs have bolstered. Until this year, the game of musical chairs has been uninterrupted as the value of used cars has appreciated where historically they have depreciated over time. However, the price of used cars has been dropping steadily, defaults are climbing, and forbearance programs are ending. In 2008, consumers lost their homes and kept their vehicles. In 2022, consumers will likely lose their cars and keep the homes they now work out of. To put a number on this, in 2021, auto lenders issued $1.4 trillion in consumer auto credit. The auto industry has historically been a leading indicator of housing and employment. It remains to be seen how the inevitable regulation affects the auto industry. Fasten your seatbelts. Pun fully intended.