The Window For A Significant Stock Market Decline Is Open

The stock market has been stagnant since late 2023. Now, there is a window of opportunity for the stock market to experience a sizeable pullback as hedging flows from this Friday's options expiration pass and economic data. supports the view that interest rates should be reduced less than what the "market", such as stocks, currencies and bonds, has priced in.

The Federal Reserve has rejected the market's view of nearly seven rate cuts by the Jan. 29 FOMC meeting in 2025. The last Fed speaker to reject the proposal was Chris Waller on January 16. Meanwhile, employment, CPI and retail sales data suggest the labor market and retail sales remain strong as inflation remains sticky. It's hard to imagine the Federal Reserve cutting rates seven times in the next 12 months.

The last Retail sales data showed a month-over-month advance of 0.6% versus estimates of 0.4%, which is better than last month's 0.3%. Meanwhile, import prices remained stable month over month against expectations of a drop of 0.4% monthly and 0.5% in November.

The view

The data appears to support the view that inflation would remain stiffer and the economy would remain stronger than expected, creating a higher and longer policy path, with a higher rate environment leading to multiple contractions and maintaining a control over stock prices. After correctly viewing the peak in July rallyeverything seemed to go as expected until the end of October, when the index returned to 4,100.

So the things suddenly and unexpectedly changed in November following the Treasury refund announcement. To make matters worse, the Federal Reserve threw gasoline on the fire when couldn't push back against the recent easing of financial conditions. This sent markets even higher, leading to a painful year-end rally in analysis that took months to complete. However, a chance for redemption has begun, as noted on December 24, when the The bubble seemed about to burst, along with my belief that the index can still return to 4,100 during the next few weeks.

The window opens

But we are now entering a period where volatility will likely increase as the VIX options expiry passes Jan. 17, and hedging flows for many mega-cap names pass the Friday Jan. 19 option expiry. . Sell ​​deltas have been building up in recent weeks on the VIX. That put delta creates a negative flow into the VIX as clients buy put options and market makers sell them to the client; Market makers then need to short the VIX or implied volatility to protect against a drop in implied volatility, since by selling puts, the market maker is essentially holding implied volatility long.

This is one of the main reasons why the VIX has been stuck below 14 since December 21. But now that the VIX option expiration on January 17 is behind us, the VIX may have more freedom to climb back up and above 14.

Single Name Flows

Furthermore, we have seen positive flows into many mega-cap tech stocks, such as NVIDIA Corporation (NVDA) and Meta Platforms, Inc. (GOAL), which may explain why these stocks have seen this continued rise in recent weeks. Over the past few months, these positive call deltas have been building up, and while it's impossible to know the positioning of the entire market, the number of open call positions and price action in names like Meta and Nvidia suggest there's a lot of Hedging is taking place that helps keep the stock at a good deal.

Assuming a client buys a Meta call and the options market maker sells a call, a market maker has essentially become short Meta. That means market makers need to protect themselves against the rise of Meta stock. This can be done in two different ways, but in its most basic forms, it means having to own Meta shares. So, as Meta shares rise, the value of the call option increases, meaning the market maker needs to buy more Meta shares to remain delta neutral. Which creates this feedback loop that keeps the stock moving.

While it is impossible to know who has what position or not, it would appear that many open calls are below the strike price of $300 or less. Given that the stock is trading around $370, there is probably a good chance that clients are keeping most of these options open as long positions.

This same options market dynamic also currently exists in names like Nvidia. In the case of Nvidia, the stock has large open positions at the strike price of $500 or less, and since the stock is also trading well above that $500 strike price, around $565, ​​the situation looks very similar to that of Meta.

The situation of Microsoft Corporation (MSFT) isn't looking much better than Meta and Nvidia, with plenty of open call options all held at much lower levels, which is probably also helping this stock rise more recently.

The internal deterioration of the market

Thus, although the level of the S&P 500 index remains stable, the stock market, in general, has been deteriorating; The NYSE McClellan Oscillator has fallen below zero, which tells us that the overall market breadth on the NYSE is weak and continues to weaken.

This is most visible when looking at the NYSE's cumulative advance-decline line against the value of the S&P 500. The advance-decline line fell below its early January low and moved away from the stock's action. price of the S&P 500.

This tells us that the index holding at current levels remains a general market illusion due to these dynamic flows that have helped support the broader indices even as stocks begin to fall again under the hood. This can be seen by looking at the stocks that have seen the biggest gains in the S&P 500 since November 1, with Microsoft, Nvidia and Meta among the top five, along with Apple Inc. (AAPL) and Amazon.com, Inc. (AMZN).

This has changed a bit since the beginning of the year, with Nvidia, Microsoft and Meta still in the top five, while Apple has become one of the biggest point losers in the S&P 500. Additionally, since the beginning of the year, 323 names in the index are lower, and only 179 are higher.

All of this continues to support "the view" that the stock market is way off the mark on rate cuts, as rates are likely to stay higher for longer, the rally remains mechanical, and as passing the January options expiration, we are now likely to see a sharp decline in market cap-weighted indices such as the S&P 500, which will likely retrace most, if not all, of the gains seen since October lows.

The road to redemption is long.