The stock market has been experiencing a lull since the end of 2023, setting the stage for a potential significant pullback. The coming expiration of options will likely bring about increased volatility and pressure for a stock market decline as economic data continues to support the view for fewer rate cuts than what the “market” has priced in.
Amidst this backdrop, the Federal Reserve has pushed back against the market’s anticipation of nearly seven rate cuts by the January 29 FOMC meeting in 2025. Recent data on jobs, CPI, and retail sales all point to the resilience of the labor market and retail sector, implying a less aggressive path for rate cuts.
January’s retail sales data surpassed estimates, exhibiting a month-over-month advance, while import prices remained resilient, defying expectations for a decline.
The Outlook
Indeed, the data seems to suggest a stickier inflation and a stronger-than-expected economy. The higher-for-longer policy path, coupled with a more elevated rate environment, is likely to curtail stock prices and lead to multiple contractions. The sudden and unexpected shift in the market’s trajectory in November was exacerbated by the Treasury Refunding Announcement, leading to a turbulent end-of-year rally. However, redemption seems to be on the horizon, with the possibility of the index returning to 4,100 over the next several weeks.
Increasing Volatility
The coming period is expected to witness an expansion in volatility, particularly after the VIX options expiration on January 17 and the expiration of hedging flows for many mega-cap names on January 19. Accumulated put deltas in the VIX are likely to create a negative flow, potentially allowing the VIX to move back above 14.
This increasing volatility is further exemplified by positive flows in mega-cap technology stocks like NVIDIA Corporation (NVDA) and Meta Platforms, Inc. (META). The persistence of positive call deltas in these stocks has led to continuous upward momentum, supported by substantial hedging activities. These dynamics have contributed to a feedback loop that keeps the stocks bid higher.
Market Dynamics
The dynamics in option markets for stocks like Meta and Nvidia indicate a parallel situation. Open call positions at lower strike prices coupled with the stocks trading well above those levels have intensified the positive feedback loop, further propelling these stocks upwards. Such dynamics also hold for Microsoft Corporation (MSFT), where open call options are held at lower levels, bolstering its recent ascent.
Deteriorating Market Internals
While the S&P 500 index level remains relatively stable, the broader stock market is displaying signs of deterioration. The NYSE McClellan Oscillator has been on the decline, reflecting a deteriorating market breadth despite the apparent steadiness of the index.
A Tumultuous Tumble: NYSE Market Breadth Weakens as Oscillator Falls Below Zero
The latest data from the New York Stock Exchange (NYSE) has sent shockwaves throughout the market as the oscillator plummets below zero, signaling a concerning weakness in overall market breadth. This downturn indicates a sustained deterioration in market conditions, raising red flags for investors and traders alike.
Visualizing Market Trends
Examining the cumulative advance-decline line of the NYSE against the value of the S&P 500 paints a stark picture of the current state of affairs. The advance-decline line has not only fallen below its early January low but has also diverged from the S&P 500’s price action, underscoring the extent of the market’s vulnerability.
Underlying Weakness
Beneath the surface, a troubling reality begins to emerge. Although the broader indexes have seemingly held their ground, dynamic flows in the market have artificially propped them up, obscuring the tenuous position of individual stocks. This becomes evident when analyzing the top gainers in the S&P 500 since November 1, with prominent names like Microsoft, Nvidia, Meta, Apple Inc. (AAPL), and Amazon.com, Inc. (AMZN) dominating the leaderboard.
Shifting Dynamics
The landscape has shifted in the new year, with certain tech giants maintaining their stronghold at the top, while others, previously stalwarts, have now become significant detractors. As of the year’s outset, a staggering 323 companies in the index find themselves in decline, while a mere 179 enjoy an upward trajectory, highlighting the pervasive weakness across the board.
Evaluating Market Realities
These developments bolster the argument that the stock market has raced far ahead of underlying economic conditions. With the likelihood of sustained higher interest rates looming on the horizon, the current rally appears increasingly mechanical. As we navigate the aftermath of January options expiration, it seems inevitable that market cap-weighted indexes, such as the S&P 500, may be primed for a substantial pullback, potentially erasing the gains witnessed since the lows of October.
The road to redemption, it seems, is a daunting one.
