It has been a very different kind of year for the stock market and this week has been no different...as the week before Labor Day weekend has not been the normal boring week we usually see in the market place. For the first three days of the week, the market rallied nicely (+2%)...but it gave back much more than that yesterday with a 3.5% decline in the S&P (and -5.2% for the Nasdaq).
The seeds for the decline were sown on Wednesday...when a small number of tech names like TSLA, ZM and APPL got hit hard. When they were unable to bounce-back in the morning yesterday (like they have on other big down-days over the past few months)...and when other mega-cap tech names (including several key chip stocks) rolled-over along with them...the rest of the market fell out of bed.
The situation that we’ve been highlighting in the options market in recent weeks...and the one that has received a lot more attention this week (with the impact of “negative gamma”) played a big role in once again yesterday (but in the opposite direction this time).
To quickly review...there has been an explosion in the buying of call options in the marketplace recently. This has taken place is some of the biggest index ETFs...as well as many of these individual mega-cap tech names. (The fact that many of these stocks/ETFs now have weekly options have made it cheaper for people to play in that market.) When investors buy these options, the brokers (or “dealers”) are usually the main seller. However, their job is to collect the fees involved in these transactions, NOT to take the other side of the trade. Therefore, once they sell those call options, they turn around immediately and buy the underlying stock or ETF (at whatever the prevailing price is at the time of the transaction), to make sure they are fully hedge immediately. (In other words, when these dealers are hedging their positions, they don’t care it the stock or ETF is overvalued or overbought, they just NEED to make sure they are hedged immediately.) When this takes place at a time when the market is rallying in a relatively straight line, it the entire situation feeds on itself...especially in today’s market where the algos are also playing such a large role.
In other words, the buyers had become VERY confident because the market was rallying in a straight line! So they kept on buying the winners (in this case, the mega-cap tech names). They also kept making money, so they become even more confident...so then they started buying call options. As this worked day after day, the buying became quite sizeable....and things really got moving to the upside. The higher it the market went, the more confidence investors gained...and the more call options they bought. This caused the dealers to buy more to keep their hedges in-line...and this helped the market rally even more. This, in turn, gave the options buyers even more confidence to buy MORE options.......This upside momentum ALSO caused the momentum-based algo players to buy more stock. That created MORE confidence...and MORE “call buying”...and MORE dealer buying...and MORE algo buying....and....well, you get the idea.
However, when these players reverse their patterns...for whatever reason...the whole thing reverses itself. Thus instead of the buying power feeding on itself, the selling power starts to feed on itself. The “call buyers” sell their calls (and start buying “puts”)...which causes the dealers to sell stocks to hedge themselves ...and the entire situation snowballs in the other direction. This is especially true when you throw-in the algos. Not only do these algos start selling, but they also cancel their “bids” (their buy orders)...which exacerbates everything in the other direction. This is what we saw yesterday and we could easily see more of it as we move further into the month of September.
This is a long-winded way of saying that what took place yesterday is exactly what we said could/should take place for a couple of weeks now...and that we could/should see more days like yesterday before this situation unwinds itself.
Anyway, the decline came on a big jump in volume, so this was definitely a concern. The composite volume was almost 3.7bn shares. That’s not huge for a normal Thursday, but it was quite high for the Thursday in the week before Labor Day weekend...and it was about 40% higher than the average daily volume of the past three weeks. That said, the breadth was not horrible. It was 8.3 to 1 negative on the S&P 500. That’s pretty bad, but not a disaster on a day when the S&P fell 3.5%. It was only 4.4 to 1 negative for the Nasdaq, so that wasn’t bad at all for an index that fell over 5%.
If there was one stand-out, it was the NDX Nasdaq 100 Index...where the breadth was a whopping 50 to 1 negative. (101 to 2...Yes, there ARE more than 100 names in the NDX 100, just like there is slightly more than 500 names in the S&P 500 index.) However, the NDX was the one index whose breadth had not been anywhere near as bad as it had been for the rest of the stock market (for the simple reason that it is filled with big-cap tech stocks), so we don’t want to make too much of this very poor number after just one day.
Of course, as we knew they would, the perma-bulls who had been telling us that there was nothing to worry about...started saying yesterday that it was obvious that the stock market was ripe for a pull-back. (Many of them told us not to worry about overbought condition of the market...and the “narrowness” of the rally...and the parabolic moves in a small number of names was nothing to worry about...etc.)
Of course, one day does not make a trend, so there is no guarantee that we’ll see more downside follow-through immediately. We get the employment report this morning, so that could help the market (although it could hurt it as well). We’d also note that the stock market usually acts well on the days surrounding long weekends. (We’ve never heard a good reason for this, but it IS true. The market doesn’t always rally on those days, but it usually does.) So there are reasons to think that the market won’t decline further immediately....However, given the amount of call buying that has taken place over the past month or more, any other decline in the stock market over the next week or two could snowball rather quickly...based on what we have described above.
None of this means that we’re about to enter a horrible bear market....like we did after the last parabolic rally in the tech stocks....but since the market’s rally had become so extreme...and taken valuations and many technical indicators to very extreme levels...the odds that we’ll see a decent sized correction over the coming weeks is quite high in our opinion...........Caveat emptor (buyer beware).
Matthew J. Maley
Chief Market Strategist
Miller Tabak + Co., LLC
Founder, The Maley Report
275 Grove St. Suite 2-400
Newton, MA 02466
Although the information contained in this report (not including disclosures contained herein) has been obtained from sources we believe to be reliable, the accuracy and completeness of such information and the opinions expressed herein cannot be guaranteed. This report is for informational purposes only and under no circumstances is it to be construed as an offer to sell, or a solicitation to buy, any security. Any recommendation contained in this report may not be appropriate for all investors. Trading options is not suitable for all investors and may involve risk of loss. Additional information is available upon request or by contacting us at Miller Tabak + Co., LLC, 200 Park Ave. Suite 1700, New York, NY 10166.