Just days before the historic Trump victory sparked utter chaos in global financial markets, we warned of 'Brexit'-like red flags in the equity derivatives markets. While equity markets did crater, it appears the unprecedented systemic-overlay of protection by the professionals was enough to create an equally unprecedented bid for US equities as hedgers covered their positions.
The massive spike in implied correlation - soaring 9 straight days from 35 to 75 - suggested fear had turned into panic.
As a reminder, implied correlation measures the relative demand for macro overlays (index hedges) vs micro risk (individual stock hedges/concerns). The higher it is, the more systemically worried investors are and the more traders believe a high correlation 'event' is due (typically the high correlation event is a big downturn in stocks).
But as the chart above shows, implied correlation has puked back to an unprecedentedly low level - over-reacting as systemic hedges are liquidated - and given overall positioning going in, this levered move has sent US stocks higher..
But, The Dow in particularly, due to its sensitivity to several high price names, dramatically over-reacting...
As RBC's Charlie McElligott notes, the rotation seen within the equities complex during the three-day period post the Trump election has been absolutely breathtaking, as the clichéd “Trumpflation” trade has destroyed the long-end and the hyper-crowded duration trade. With it, the already massive “into cyclicals / out of defensive ‘low vol’ bond proxies” trade in equities experienced since mid-Summer’s secular global bond yield lows has accelerated to unprecedented levels. Same with small cap over large, due to the obvious “economic and DOMESTIC gearing” of smaller companies (even though the hard data shows that small caps are more sensitive to higher rates).
This should be a beautiful thing for active managers, as we are seeing MASSIVE dispersion in the market place place, as evidenced by the total breakdown in implied correlation (as viewed by the JCJ index) over the past week.