The S&P 500 May Be Heading Back To 4,100 Sooner Than You Think

Stocks continued to rally this week, with the S&P 500 climbing by 1%, approaching their July peak. The rally has been a 3-part move primarily due to a market in a net short gamma position, systematic flows, and volatility selling.

These are primarily a function of flows and positioning and have nothing to do with improvement in the fundamental outlook for the economy or earnings growth. This is important because mechanical flows are subject to swift and sudden shifts.

Those sudden shifts could start this week, with Treasury auctions back, Jay Powell speaking ahead of an FOMC blackout period, and credit spreads approaching a key level, which could start the unwind of the November rally and a push lower in the S&P 500 back to 4,100 over the coming weeks.

Mechanical Forces At Work

As previously noted, the rally was likely due to a sudden and sharp shift in options market positioning following the Treasury Refunding announcement that sent rates lower on November 1. This initiated a short covering rally in the options market due to a negative gamma regime.

Net gamma’s position in the S&P 500 reached its most negative point over the past year towards the end of October. When the broader market is net negative gamma, it means that market makers are sellers of the S&P 500 as the market moves down and buyers of the S&P 500 as the market moves higher. This triggered that very sharp and violent move in the S&P 500 starting November 1 because, at that point, the 10-year Treasury was near 5%, and the S&P 500 was selling off with rising rates. However, the Treasury Refunding announcement sent rates lower and stocks higher and started this mechanical process.

The data also shows us that currently, we have entered a positive gamma regime, and that means that market makers become sellers of strength and buyers of weaknesses, which helps to suppress volatility and, more importantly, means that any move higher in the S&P 500 is likely to be in the form of a slow grind.

Additionally, after the initial surge, the next wave of buying was triggered by systematic funds, which helped to create that mechanical movement in the index. However, the explosive part of the rally started to slow down as we moved into mid-November because the short-covering aspect ended, and the systematic aspect began. Over this time, changes in S&P 500 futures contracts showed that asset managers began to increase their net-long exposures.

However, data from Goldman Sachs now shows that the systematic flows that helped to drive the market higher off the initial short-covering surge have died out. If, for some reason, the market should start moving lower, it could result in these systematic funds flipping back and becoming sellers again in a down market.

How The Rally Started And Its Impacts

It is important to remember what started the move in the equity market was due to a plunge in yields. Suddenly, rates may be coming back into focus and are beginning to show some signs of life after bouncing back this past week, and technically appeared to be breaking out, which could result in the rates pushing higher, especially on the long end of the curve with the 10-year moving up again.

The VIX also saw its lowest close on January 17, 2020. This is odd because, arguably, this is a different moment than January 2020, which was pre-pandemic when inflation rates were lower. The Fed was cutting rates due to slowing growth while also starting to buy bonds again to increase reserve balances.

The collapse in implied volatility is not in isolation because credit spreads have fallen while financial conditions have once again begun to ease. These past few weeks have seen the CDX High Yield Index fall back to 400 and is at a point where it will have to collapse along with financial conditions completely or turn around and start pushing higher again.

A Pivotal Week

All of this comes at an interesting point because this week, Treasury auctions will be back, with the Treasury selling $54 billion 2-year notes on November 27 at 11:30 AM ET and then selling $55 billion 5-year notes the same day at 1 PM ET. The Treasury will sell $39 billion of the 7-year note on November 28 at 1 PM ET. The auctions have been a source of volatility for the markets overall. The 30-year auction on November 9 did not go well, and now it was just the 10-year TIP auction on November 21 that did not go well, with the high yield coming in at 2.18%, above the when-issued rate of 2.145%.

It also comes during a week when Jay Powell will speak on December 1 at 11 AM in a fire chat, ahead of the blackout period for the December 13 FOMC rate decision meeting, as financial conditions have eased back to the level last seen before the September FOMC meeting, based on the Goldman Sachs Financial Conditions Index.

Powell and the Fed minutes already clarified that tighter financial conditions could substitute for rate hikes if persistent. However, financial conditions have not been persistent and have given back more than 60% of the tightening witnessed since July.

It would seem that this is a week that could serve as a turning point in the recent bull narrative because we know that what largely drove the index higher was the decline in Treasury rates, followed by the mechanical bid in the stock market, which helped to ease financial conditions and bring the markets back to this point.

But if rates due turn higher, and financial conditions begin to tighten, then it wouldn’t take much of a move in the S&P 500 to shift the index back into negative gamma and trigger the systematic flows to flip back from buyer to sellers, implied volatility to rise, and credit spreads to widen, to unwind much of, if not all of the rally off the October 2023 lows sending the S&P 500 index back to 4,100.