It’s time for another Charts of the Week, and we have a lot to cover this time so let’s get right to it!

Volatility, what volatility?

Volatility in the S&P 500 is approaching pre-pandemic lows recently, driven by a variety of factors. An increase in 0DTE trading has helped to compress volatility as we’re seeing more opinions expressed within shorter time frames and smaller price ranges. We also have a lot of vol selling funds getting more aggressive.

Even the volatility of volatility has been rather subdued, with the 3-month change in SPX implied volatility nearing lows for 2023.

Dealers are quite short volatility here, with call skew rather elevated in the VIX. Some, including Goldman’s vol trading desk, have speculated that we may actually be seeing a low in volatility here, and have suggested that clients consider using it as an opportunity to hedge.

The divergence between the MOVE index and the VIX also suggests that equity volatility may be too cheap. Personally, I look at MOVE as being the big brother index because I feel that the bond market is actually more important than the equity market. That is to say, I feel that when the most important rate setting market in the world is more uncertain than equities about price, it’s probably best to watch the rate market more closely for clues.

Everyone wants a piece of the action

With subdued volatility, one can reasonably expect an abundance of optimism in equities, and with good cause. We’re in a very powerful time of year for positive seasonality in the S&P 500.

We’ve seen the change in sentiment from being washed out to now being rather effervescent with optimism. Flows into equities from a variety of sources have surged.

Retail flows, shown below from JP Morgan, have also surged to 2023 highs. Back to levels not seen since early 2022.

CTAs, not content to miss out on the action after having rather significant short exposure, just clocked in 10-day flows of about $70B in US equities. The largest such inflows since 2014.

Corporate buybacks were also rather profound, with two of the strongest weeks ever behind us.

Hedge funds didn’t hedge well in 2023

This has been a rather challenging environment for active managers, and in particular hedge fund strategies have not performed well in 2023. Gross leverage has been rather high compared to prior periods, but net exposure remains subdued, meaning funds didn’t have enough long exposure to truly benefit from the concentrated surge in US mega caps this year. Despite hedge funds having about 13% of their long portfolio in the same group.

Seen below, long/short hedge funds are experiencing the worst comparative performance vs the S&P 500 in a decade. More and more funds are flowing from active managers, like hedge funds, into passive ETFs, and this sort of underperformance is likely to encourage more of the same.

Are we past peak AI euphoria?

During Q3, mentions of AI during conference calls dropped from 35% to 29% for S&P 500 companies. Are we past the peak of mentioning AI as many times as possible to keep equity prices afloat?

We’ve yet to see one key development that would help me feel a little bit more sanguine about the excitement: a broad-based increase in productivity (and as a result margins) attributed to AI by companies investing in it. We’ll see if that changes during Q4 earnings season.

Are we there yet?

Many are calling for a peak in the Fed’s hiking cycle, and they may indeed be right. It is rather rare for the Fed to hike after long pauses. The current chance of a hike in December, for example, is measured at just 4.2%.

In fact, as early as March of 2024 the odds of a cut are as high as 44.4%, and 74.5% in May, based on CME Fed Funds Futures.

Does this mean that companies will finally feel some relief in borrowing costs? Small businesses all the way to swaths of the S&P 500 have been impacted by the highest borrowing costs in about 16 years.

While some of the largest companies have benefited from rising net interest margins due to their longer term debt financed at lower rates than what they’re earning from cash, and less leverage on their balance sheet as a whole, the overall increase in the cost of capital is having a drag effect elsewhere.

Rising rates have also drawn an incredible amount of capital into global money market fund assets. The question becomes whether when the rate hiking cycle is over and we begin to see cuts as being credible and imminent, where do these funds go? Will they flow into longer duration debt? Equities? Other asset classes?

We’ve yet to see. The assumption that this cash “parked on the sidelines” automatically translates into equity purchases may not be well-founded, however, with an increasingly aged population holding the majority of wealth in the US and other developed countries. In essence, savers that want a stable income rather than speculating for returns on capital. Current rates offer a generational opportunity that did not exist just two years ago.

Is that why gold is so resilient? Is the metal sniffing out an end of the hiking cycle and thinking that cuts may come earlier than expected? The divergence between gold and 10-year real yields certainly suggests that as the relative strength has been remarkable.

Support small businesses

In closing, I wanted to leave you all with a different sort of thought this week. Small businesses are the largest creator of jobs in the US, and small retailers are an important part of that paradigm.

This is the most important time of year to consider showing support for small businesses in retail, as holiday shopping season can make or break these shops.

I would encourage you to consider supporting small retailers this holiday season and beyond to help ensure those companies, and the jobs they create, continue to have a chance to succeed in an increasingly challenging economic environment.

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