"Does Yesterday's Selloff Have Legs?" - Morgan Stanley Answers

Tyler Durden's picture

Does yesterday's modest - if sharp - selloff in stocks have legs? That is the question Morgan Stanley's Institutional Equity Division director Chris Metli asks in a note to clients overnight. As Metli writes, the moves have been exacerbated by the lack of protection investors have on and their rising equity exposures over the last month. 

The below charts update the positioning in options and futures that QDS noted two weeks ago – in general investors have continued to get more bullish.  Meanwhile, as MS Equity Strategist Mike Wilson has noted 3Q earnings are now largely in the price and with the SPX rally overextended, earnings season should be a ‘sell the news’ event as there is "greater risk for a correction than we've seen in a while".

So "does this move lower have legs?" 

The above charts suggest that there are a good amount of recent positions put on that are offsides and need to come off, and that suggests that this may not just be a one-day move lower.  As noted previously there is a lack of protection on in the 2400-2500 range so if the market can break 2500 there could be an ‘air pocket’ on the downside until there is ammo to actually buy the dip.

However, whether the market can move lower could come down to whether the consensus positions under the surface of the index (i.e. long / short trades) feel more pain and cause broad based de-risking. 

The selloff will help clear out some of the faster money put to work recently, but the real pain would come from consensus long / short trades reversing (largely Tech vs Energy and cyclicals).  As a proxy for this pain trade QDS tracks the MS Momentum baskets and the MS Passive basket (which tends to rally when active managers underperform).  None of them are melting down, but their performance will be key to watch going forward.

As noted two weeks ago, as the end of year approaches the risk of unwinds should increase.  Investors still benefit from a positive performance ‘cushion’ this year and most positions are in-the-money.  But nobody wants to give that alpha back and underperform peers, meaning traders could be quicker on the unwind trigger from here on out.  This should contribute to moderately higher volatility levels in general, and whether it accelerates into a full on pain trade will be driven by whether there is a catalyst.  With Tech and Growth stocks the biggest crowded positions, earnings over the next week will be a key test.

With risks rising into the end of the year, but fundamentals still strong and still plenty of upside to MS Equity Strategist Mike Wilson’s 2700 price target, QDS suggests:

  • Hedging QQQ (given crowding in Tech) and IWM (given tax reform risk) with ratio put spreads given volatility is relatively elevated in both vs SPX:
    • Buy QQQ Dec 145/140 1x1.5 put spreads for ~$0.50c (33 bps) which have a max risk / reward of 9x while not taking downside risk unless QQQ falls more than 12% to levels last hit in April
    • Buy IWM Dec 145/140 1x1.5 put spreads for ~$0.45c (30 bps) which have a max risk / reward of 10x while not taking downside risk unless IWM falls more than 12% to levels last hit in Nov 2016
  • Rotating long beta / broad-market positions into upside SPX calls (i.e. stock replacement)
    • Buy SPX Jan 2625 calls for ~50 bps, 8 implied vol

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LawsofPhysics's picture

The coordinated effort by the Fed and it's primary dealer banks that has been ongoing since 2009 and is still ongoing has already provided enough liquidity to raise prices 1,500-1,600% so far...

...imagine if all those paper/digital claims actually started to seek out real assets on main street.

Personally, I feel lucky to be a producer of food in such an environment, especially given the technology for efficient food production that has been coming online. Looking forward to the future bitchez and I sincerely hope you have something real to offer in exchange for the products of our labor!

"Full Faith and Credit"

spastic_colon's picture

very curious how the futures (DOW) are up 55 and not one of the 30 components appears to be trading up in pre-market.........

LawsofPhysics's picture

No market for true price discovery, period.  Perception management, nothing more.

Head's up regarding nut futures (walnuts, pecans etc.)...  we have already lost 40% of the bee hives we normally use to pollunate these trees with.  Working on bringing the population back now, but will definitely increase costs that I happily pass on...

fbazzrea's picture

southern Oklahoma pecan crop is virtually non-existent this year... could be widespread.

LawsofPhysics's picture

Yep. California not doing much better either.  Damn, just realized I mis-spelled "pollenate"

toady's picture

Florida oranges are fucked too... possibly for years. Really glad I started the "farm" in 2010! The orchard is just starting to put out large numbers and the corn has been good two years in a row (who knew growing corn would be so difficult?)

I suppose I need to look into bees.... but, BEARS!

fbazzrea's picture

"pollinate" lol damn English (;

Skeptophrenic's picture

A simple yes/no would suffice. Thanks

LawsofPhysics's picture

Indeed, all this tells me is that it keeps getting harder for all those social scientists to justify their compensation...

buzzsaw99's picture

yeah and maybe they have underperformed so far ytd and need to push stocks higher to get their bonus.  selloff, LOLZ.  protection, LOLZ.

DavidC's picture

Spot on buzzsaw.


buzzsaw99's picture

buying protection doesn't get you a bonus.  i think they've figured out that much by now.

DavidC's picture

Yesterday's 'sell off' did not even get below the previous day's low. It was a sharp move for sure but mostly recouped. Sell off? No.


RagaMuffin's picture

"lack of protection investors have on...."  When was the last time that you ever heard of someone wearing  bullet proof vest did not duck when the shooting started? Further, if the market rallies, does it mean there is too much protection?......jeesh....

buzzsaw99's picture

the big trading houses are always keen to sell protection the same way a blackjack dealer wants to sell insurance.  good for them over the long haul, bad for you.  if i'm so scared that stocks and bonds will decline then i am selling my stuff not buying bullshit protection.

Snaffew's picture

after tonights earnings onslaught, the market may rip off to new ATH's....yesterday's selloff could turn out to be just another bear trap.

Jtrillian's picture

What sell off?  Clearly they don't know about the BOJ or the ECB (they KNOW... they just don't want you to know). 

Snaffew's picture

considering the S&P barely registers down days more than 2 points...yesterdays 30 point dump can be considered a selloff


Goldbugger's picture

The PPT is still fully staffed. Gold should be headed to 1200 and the dollar ready to run up for it's last harra.