One of the vexing problems that has emerged this earnings season is why, despite blockbuster earnings, do most stocks fail to rise, or in many cases sink promptly after reporting stellar numbers.
According to Morgan Stanley's Chris Metli, executive director in the bank's Institutional Equity Division, the answer is as follows: on one hand, the the dollar has begun to move higher alongside yields which suggests rates are getting to a point where they could limit further upside, and stocks didn’t rally much on good earnings suggesting expectations are already high.
But while that reason explains the prevailing grind in the market, and the recent lack of momentum and direction, the real reason for the lack of rallies on strong earnings is that "hedge funds remain very crowded in the same positions (i.e. Tech) and there are fewer marginal buyers left."
But before we get into details, here are some more reasons why Morgan Stanley believes that the best the market can hope for here is a slow, painful grind higher:
A grind higher is consistent with what last week’s price action tells us: the dollar has begun to move higher alongside yields which suggests rates are getting to a point where they could limit further upside, and stocks didn’t rally much on good earnings suggesting expectations are already high.
That's a problem because according to the MS trader, a grind may disappoint some investors hoping for a quicker snapback – option market flows have had a bullish tilt lately and the market implied probability of a 5% gain is greater than a 5% decline over the next 3 months.
Investors should consider taking advantage of this pricing while positioning for a grind higher by overwriting longs or buying calls spreads or call ratios.
Taking a step back, what is positioning and recent price action telling us here? Here is Metli's response:
Macro shifts are a headwind as yields are rising alongside the dollar. This partly reflects the better US growth outlook vs the rest of world, but the follow on is that it could tighten financial conditions – meaning less potential equity upside.
- This feedback mechanism is why equities tend to become more correlated to bonds when interest rates become more correlated to the dollar (see chart below)
- Macro correlations measured over the last several months don’t show any shifts – but over the last week the stronger dollar has come alongside higher yields, particularly real yields – if this continues, it is a headwind for stocks
- For now higher yields are more of a headwind than a negative catalyst
- But any increase in stock-bond correlation does raise the specter of risk parity fund selling, which have not delevered as much as other systematic funds.
This brings us to the key observation, namely that stocks are not rallying on strong earnings, and here is the paradox in a nutshell: 80% of SPX names have beat earnings vs 67% historically, but the SPX is down 1.3% since earnings started and importantly the market could not hold on to the Thursday post-close rally
Here is the reason "why" according to Morgan Stanley:
Very simply HFs remain very crowded in the same positions (i.e. Tech) and there are fewer marginal buyers left. The MS PB Content team has noted that HF gross exposures remain elevated, and from conversations with investors this positioning was driven by optimism over 1Q data.
The bank then looks broadly across investor types, and asks, rhetorically, "who is left to buy?" Here is its unsatisfactory answer:
- Retail has been selling (passive funds saw the biggest outflows since 2009 over the last 3 months, see charts below) and likely remain on the sidelines due to the increase in volatility
- Likewise systematic investors are unlikely about to buy too strongly as volatility remains elevated
- HFs have hung on to their positions over the last few months as they have benefited from a positive ‘performance cushion’ with the average fund up 1 to 2% YTD per the MS PB Content team. But recent returns of the MS Momentum baskets suggests performance is struggling (MSZZMOMO for fundamental-like sector-biased / MS00MOMO for quant-like sector neutral – see chart below). And MS Equity Strategist Mike Wilson has written about the lack of leadership in US equities (see Leadership in Transition; Buy Energy and Fins; Sell Semis and Retail, April 23 2018) which could challenge consensus positions further (see chart below).
- Corporates will start to re-enter the market as earnings season draws to a close, but these flows argue more for less downside than explosive upside as buybacks are a drip not a flood
- Asset managers and more macro-focused investors could provide some demand but their flows have been choppy (selling in Feb and March has turned to very modest buying in the last week) and they remain a wild card
Given the above, Metli believes that "the path forward will likely be one of continued chop around a grind higher. The chop is driven by P/E volatility as investors debate how close the economy is to the end of the cycle, with the grind driven by a continued steady rise in forward EPS."
Finally, some suggestions on how to trade the "chop", which is challenging for directional users of options in that the choppiness raises option prices in this environment, but does not necessarily widen the range of the market to the same degree.
* * *
So while Morgan Stanley's quants view near-term volatility pricing as roughly fair from a dynamic hedging perspective, "if buying options to benefit from price movement they are a little rich – hence the view to overwrite or play the upside via call spreads."
Longer-term, however, the bank remains bullish on volatility given the nearing turn of the cycle – but for directional users of options it is better to wait until there is a catalyst for a crack in earnings, which will drive a true break of the range.
Morgan Stanley's suggested trades: Investors should consider call spreads on SPX, or overwriting the higher volatility NDX:
- Buy SPX May month-end 2725 / 2775 call spreads for ~50 bps, 2.9x max risk-reward
- Sell QQQ June 170 calls for 76 bps (5% OTM)
The main near-term risks to these limited-upside trades is a trade war de-escalation after Mnuchin’s visit to China or geopolitical progress in Korea – investors more positively inclined on the outcome of those events may consider waiting for them to unfold before playing the more structural themes above.