We now have a basic understanding of what powered the 2020 rebound rally, which then morphed into a lockdown mania, and which now appears to be over.
This is important because, with a sense of what happened — and the various components involved — we can better understand the probability distribution of what is likely to happen next.
From the current vantage point, it looks like the rally was powered by “rocket fuel” that is now running low, and may completely run out in the next few weeks (if it hasn’t run dry already).
Before explaining the rocket fuel, here are some relevant pieces for context:
- June 12 — A Requiem for the 2020 Lockdown Mania
We already know the rally was extraordinary. For the S&P 500, it was the most powerful 50-day rally ever.
By the end, signs of mania were everywhere. Bankruptcy stocks tripled and quadrupled. Penny stocks flew like turkeys in a hailstorm. Zero-commission brokerage accounts were opened en masse. Retail investor sentiment, as determined by various measures, was at its most euphoric levels since 2000.
The flow of retail money into the stock market was magnified in its impact via the aggressive use of call options.
According to Jason Goepfert of SentimenTrader, speculative call option buying surged to its highest level in 20 years. The Put/Call ratio, another key sentiment indicator, also saw its most euphoric reading since the dotcom bubble.
A call option is a concentrated form of “non-recourse leverage.” By purchasing a call options contract, you get upside exposure to 100 shares of stock for a fraction of the cost it would take to buy the 100 shares outright. “Non-recourse” means you can’t lose more than what you pay, an important feature. An options buyer cannot lose more than the purchase amount.
When large swathes of retail traders buy call options — and especially when they do so in the same stocks — it leverages the impact of their capital. As a trading vehicle, mass-purchased call options were thus like nitroglycerine mixed into the fuel.
This is because the inherent risk in an options contract is also a form of risk for the market maker — the person or entity who sells the option when the retail investor buys it.
If the buyer of a call option gets it right, the value of the option will go up a lot, causing the individual or entity who sold the option — the market maker — to lose a lot. The market maker, who prefers to be “market neutral,” thus hedges the position risk (which was created by selling the option) by going out and purchasing actual shares of stock.
This share-buying by market makers — as they offset the position risk of selling call options, while retail investors aggressively buy them — is called “delta hedging,” and it directly impacts the stock price in a bullish way.
And because the market maker more or less has to buy 100 shares to fully offset the risk of selling a 100-share options contract, the fractional funds invested in the call option purchase have a magnified market impact.
Another aspect of all this is the way aggressive market strategies were shared and disseminated on social media. It is easier for semi-sophisticated strategies to spread like wildfire when individuals who use such strategies have natural incentive to share them and teach them. The incentive is increasing the size of the crowd, which then increases the buying impact, potentially turning the hoped-for bullish outcome into a self-fulfilling prophecy.
As a result of social media proliferation, moderately odd or sophisticated strategies like using call options to magnify exposure, or buying up penny-stock bankruptcy names in market-moving unison, were not discovered en masse by accident. Instead the strategies were actively spread, and even evangelized, on message boards, in online gamer chat rooms, and so on.
The problem here — for bulls — is that all this rocket fuel is going away.
The $1,200 stimulus check, for example, was a one-time thing. We may see another round of direct-to-consumer stimulus from Congress, but the economic situation would likely have to turn dire before that happens.
The first round of stimulus checks, meanwhile, occupied a kind of one-time optimism window in which it was still possible to believe in a V-shaped recovery narrative.
If stimulus comes again, serious damage to the U.S. economy will almost certainly be apparent, disabling the crucial bullish psychology aspect of the rocket-fuel mix.
Then, too, the topped-up unemployment benefits, putting an extra $600 per week in unemployed Americans’ bank accounts, is set to expire by July 31.
Those benefits, too, might wind up being renewed or extended. But there will be a fight in Congress to make that happen — and once again, the dire economic circumstances in which a new stimulus top-up is approved will likely not be bullish for the market.
Last but not least, the leverage magnification via call options might be the least renewable part: Buying short-term call options en masse only works when markets are flying high, which is why such strategies are associated with super-bullish conditions.
If you take away the super-bullish conditions part, the options tend to experience rapid decay, like ice cubes left in the sun, and the bullish mood evaporates as rapidly as the funds in the trading account. And as call option buying dries up in a mania’s aftermath, the market maker starts selling shares to close out their delta hedge long equity positions — which puts more downside pressure on the market.
What about the Federal Reserve? Can’t they save the day?
Not for stocks they can’t, no — unless something extraordinary happens, which in this case means extraordinarily bad, as in, worse than what we’ve already seen.
Remember that the Fed provided the psychological component to the 2020 rally, not the actual fuel boost. The Federal Reserve remains constrained by the “lending not spending” narrative — they can buy debt and provide loans, but they can’t inject currency into the market.
To keep the rally well-fueled, three components are required: Bullish monetary policy and rhetoric from the Federal Reserve, fiscal helicopter stimulus from the government, and a bullish psychology backdrop that fuels a willingness to speculate.
That recipe is gone, which means the market will have to make do with the fuel it already has. That fuel is now running low and could soon run out completely (depending on how quickly retail sentiment turns bearish). If retail investors back away, and professional managers remain skeptical and cautious, then bullish flows could disappear.
As another point of concern, 401(k) match flows — another form of bullish market support — are now being slashed, as Bloomberg Law reports:
The pandemic is affecting one of the best perks of workplace retirement-savings plans: company matches to employee 401(k) contributions.
Many firms in the hard-hit hospitality and retail industries have already suspended, reduced, or deferred matches, including Expedia Group Inc., Hilton Grand Vacations Inc., and Best Buy Co.
Even with the recent rally in stocks, many more companies are planning or considering such a move… Companies see suspensions as a way to boost cash flow and avoid or limit job cuts — although furloughs and layoffs have been plentiful this year.
As layoffs eat into the knowledge worker space and work-from-home employees get pink slips — this, too, will prove inevitable in a struggling economy — we could see a surge of laid off work-from-homers not only stopping their automated 401(k) contributions, but actively tapping their 401(k) accounts, withdrawing funds and selling stocks to do so, as a means of harvesting emergency savings.
In sum, the rocket fuel is running out, the valuation case is not there (barring a v-shaped recovery fantasy), and the Federal Reserve is not positioned to stop a decline from happening.
Unless, of course, Federal Reserve Chairman Jerome Powell figures out how to circumvent the Banking Act of 1933 and do something radical — a move which might require far lower stock prices for him to try.