One day after a near record point drop in the Dow Jones, one which soaked up margin purchasing power for both retail and professional investors and put many traders in deficiency on their maintenance margins, the key question for today - according to Morgan Stanley - is who will be forced to trade?
As MS' derivatives strategist Chris Metli writes in his latest note (he has been quite busy today), it’s useful to compare this episode to February. Here, on one hand forced systematic selling should be less now than then and importantly is better understood by traders (likely <$50bn in total supply, see #3 and #4 below for details). On the other hand, the pain for the equity discretionary and quant communities is worse this time and they are sellers not buyers, and that is important because it impacts a broader community of investors.
Said otherwise, if this unwind continues it is because discretionary funds continue to de-risk.
As for what Morgan Stanley thinks, calling whether there is more de-risking to come from fundamental and quant investors is a tough call, but a) a short-term bounce is possible but b) it will be followed by more weakness. That's because while the biggest single shock has likely already happened, "this de-risking could still take a few weeks to fully play out."
Below, Metli breaks down the details behind these observations in 4 pieces:
1. The biggest issue today is that fundamental funds are feeling a lot of pain. The February shock was a correlated event that happened early in the year when funds were feeling good, and many fundamental investors bought that dip. Now the firepower to buy the dip is much lower given it is late in the year and:
- Crowded positions have been building for years and are likely not fully unwound
- Recent P/L has been the worst since February 2016
- The volatility of what people own is very high
How much has been unwound is the key swing factor. There clearly has already been heavy selling across the globe as factors and themes moved multiple standard deviations yesterday and over the last week (see previous QDS pieces for details in the US, and the attached work by Rob Cronin for an excellent analysis on European flows). But arguably there is more to come given years of positioning buildup.
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2. Also different now is that global central banks are now withdrawing money from the economy, market liquidity has yet to fully rebound after February, and today is the peak of the buyback blackout window (vs ½ in blackout during the February selloff).
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3. On a positive note, both CTAs and option market positioning is much cleaner now than in February so there will be less forced selling from these traders:
- Market makers will not be forced to sell as much stock or buy as much volatility: market makers do not get as short gamma or vega on the downside and the VIX complex is cleaner
- CTAs have less to do. Yes they could have sell to $10 to $30bn of US equities, but this pales in comparison to the ~$100bn they likely sold of global stocks in February. Why? Equity leverage is likely 1/3 of what it was then and could even be short in ex-US markets, and trend followers are likely leaning short bonds here so making money here that lowers the likelihood of being stopped out.
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4. Back to the negative side of the ledger annuities and risk parity funds were running high leverage coming into yesterday’s shock, and they will be forced to sell in the coming days:
- QDS estimates about $25bn of equity supply from these investors over the next several days (on top of ~$6bn yesterday)
- Should equities go another 2% lower today there would be an additional $20 bn of supply over the next few days
- For context these investors likely sold ~$100bn during the February shock
And while Morgan Stanley concedes that these numbers may be scary, they may also be priced in. In other words, while systematic supply will be an overhang on the market, but the awareness of these strategies and their impact is so much higher today than a few years ago that the market ‘knows’ how to deal with it. It’s also possible that this awareness pulled forward some of the supply into yesterday, which means less net selling going forward – the MS futures team notes that the open interest change yesterday was the biggest indicative increase in shorts going back over 6 years.