What Will The Next “Market Bottom” Look Like

Liquidity is dismal, with even Goldman warning that “this chart should be on everyone’s radar. This is the top of book depth of S&P futures divided by 1mo ATM vol. It is flashing red. The set up for an equity market crash is as high as I have seen it.“

… Meanwhile, predictably, volatility is explosive and refuses to ease amid the continued selling…

… which means that one week after the S&P 500 fell by 9% in the month of April – its worst month since March 2020 – the bloodbath has continued, with the S&P tumbling below 4,000 for the first time in over a year.

Discussing the latest market dynamics, Morgan Stanley – which has been quite bearish on risk over the past year – thinks that in the medium-term, the market is likely to trend lower, but near-term, the market could be due for a quick squeeze higher. It does say that any short squeeze should be faded as it is unlikely to be sustained (as it should be interpreted as a bear market rally). As such the bank’s Quants and Derivatives desk (QDS) still prefers to lean short the market but to hedge with long upside calls.

Why? Here’s how QDS views the recent price action and why it sees odds for a major bounce here as modest.

The recent price action and much of QDS’s forward-looking view can be best understood through the lens of positioning. Positioning of “fast money” market participants, such as Hedge Funds and systematic macro strategies (trend following CTAs, vol control funds, and risk parity funds), is very light, both sitting in the sub-10th percentile over the past 5Y. And while short interest is no longer as extreme as it was a couple of months ago, extremely light net positioning + a touch of ‘FOMO’ + challenging P/L suggests that there could be plenty of interest to chase the market higher on any rally.

On the other side of this fast money are the “slower money” market participants – institutional real money plus retail: as discussed yesterday when we noted that Monday was the 5th biggest selling day on record, they have reversed their recent dip-buying and have been been driving more of the sell pressure and, according to Morgan Stanley, are likely to continue to drive price action in the medium-term. That’s a problem since retail demand has begun to slip…

… and retail will likely be less supportive to the broader equity market going forward especially since all post covid gains – including the meme stock frenzy – is now gone.

Retail demand has been weaker than expected relative to seasonal trends post-tax day, estimated retail P/L is deteriorating, and inflation is eating away at individuals’ disposable income. Retail has been an important buyer of dips, and with the retail bid dissipating just a lack of buying is likely enough to create an air pocket in the medium-term.

Which bring us to the question everyone wants answered: what could the next ‘market bottom’ look like given these positioning dynamics? 

According to MS, signs of a market bottom are unlikely to resemble traditional “capitulation” that’s played out in the last few years. Why? Because traditional capitulation is typically marked by a quick de-grossing by hedge funds + systematic macro strategies, where positioning is already light. Instead, the next leg of de-risking is likely to be more gradual, coming from asset allocators/real money/retail and is therefore likely slower to play out, making a precise bottom more difficult to call.

JPMorgan, always far more cheerful than Morgan Stanley, as the following S&P chart annotated with Marko Kolanovic’s weekly recos to buy each and every dip shows…

… is obviously more bullish, and also takes a stab at answering the question “how close are we to the bottom and is Wednesday’s CPI a positive catalyst?” Here is JPM’s Andrew Tyler response who notes that “those were the two most asked client questions on Monday”:

Before trying to answer those question, let’s take a look at markets. Yesterday’s moves, which included a 3 standard deviation sell-day by Retail make some feel better but the SPX failing to hold 4k will make others nervous. Marko points out that ARKK is trading where it was the second week of Marcy 2020. Biotech is trading below pandemic lows. R2K is trading near the level of Summer 2018. All of these data points were before Fed Liquidity and stimmy. Combined this is a likely oversold condition.

Returning to those client questions, they do not have to be mutually exclusive. Did we see a bottom? I have no idea but on a 2-3 month basis, I think buying at these levels makes some sense but it is tough to think one should be putting on material risk ahead of the CPI print. For CPI, Feroli is above the Street and it is entirely possible that we may have one or more elevated prints before we start to see a significant decline in official measures of inflation. Overall, I think there are some opportunities but still prefer to hold a market-neutral portfolio.

I agree with Marko’s assessment that there is a ton of irrational behavior surrounding the growthier parts of the market. BUT. I am sure we all remember the quote about markets, irrationality, and solvency. That said, a near-term play that makes sense is the Energy complex. While the recent move higher was fueled by sentiment surrounding an energy embargo, there supply/demand dynamic is supportive of prices and it is tough to see WTI spending much time below $95-100 range as we approach seasonal demand.

And there you have it: one bearish take, one bullish. Ironically, even the bulls are now tripping over themselves to build a narrative, because in the same note that JPM tries to cobble together a feeble bullish case, another trader goes back to what we have long claims is the biggest and most important variable for any sustained rally – lilquidity… or the lack thereof. Here is JPM flow trader Joel Nyback discussing – what else – market liquidity:

ESM2 top level averaged 13 contracts today and spent 25% of the day ≥2ticks. To put that market width in context, there have been three periods since Jan 2020 where more than 20% of the day was spent ≥2ticks. The first was during the COVID selloff and the other two were earlier this year. The precedents suggest it will be a while before we see the environment meaningfully improve. Intraday realized volatility was 23v and volumes marginally lower than last week. We shouldn’t expect anything helpful here for at least the next week.

In other words, bias and narrative aside, the only thing that matters to markets right now is liquidity (i.e., confidence), and without at least a modest bounce there, stocks will have an extremely difficult time bottoming, let alone rising.

For more, please read the full MS and JPM notes available to professional subs in the usual place.