Equity markets have become so complex as to defy explanation

Something very unusual occurred on January 24. The S&P 500 slid 4% in morning trading, only to reverse course and close marginally up for the day. Never have US stock markets swung this wildly outside of a financial crisis.

A market anomaly of this magnitude demands explanation. There is no shortage of theories, but none of them on their own are particularly convincing.

The simplest explanation, according to some, is that this was simply a tale of ultra-bullish investors buying the dip. Others think the answer lies in options positioning and associated gamma hedging from dealers. A more controversial theory suggests the close-out of a few big puts around lunchtime reversed the selloff. Some reach even further into their options anoraks, singling out vanna – a second-order Greek that measures the sensitivity of an option’s delta to changes in implied volatility – as the main culprit.

It is entirely possible that these theories are not mutually exclusive – and there has been surprisingly little effort to square them. This could be a story of multiple narratives coming together in a climactic twist.

The central elements of the morning selloff are fairly well established. Equity markets were jittery leading up to the slide. The S&P 500 was already down 7% for the year; liquidity was poor. Rising inflation, impending rate hikes and escalating geopolitical risks added to this fragile backdrop, setting the scene for Monday’s dramatic slide.

In some respects, the confusion over what caused the intraday reversal may be more telling than the rebound itself

It’s the inflection point where things become murky. The idea that a few big puts being closed out could reverse the world’s biggest equity market – even considering the impact of dealer hedging – seems far-fetched. But there is clear evidence of midday trades that seemed to run against the bearish tone. This would have created deltas for dealers to buy to hedge their options books. The resulting dip in volatility may have been signal for systematic trend followers to sweep in, sparking a frenzied end-of-day rally. There may be a smattering of truth in all the theories under discussion.

But in some respects, the confusion over what caused the intraday reversal may be more telling than the rebound itself. The fragmented and uncertain explanations reflect the fragmented and uncertain nature of equity markets themselves. In the pandemic era, many things have become unrecognisable, and equity markets are no exception.

An army of retail day traders have used lockdown savings to drive record activity in options markets, sometimes pushing prices to levels that defy fundamentals. At the same time, systematic investing has ballooned, with billions bought and sold based on technical analysis of all sorts of data – some of it patchy at best. Investors have piled into leveraged exchange-traded funds, which rebalance daily. “That’s a structural change in the last couple of years that could have contributed to an increase in intraday vol,” says Peng Cheng, head of big data and AI strategy research at JP Morgan.

On the macro side, inflation has hit levels not seen in a generation. The sky-high valuations of the handful of tech giants that have propelled the three-year bull market may no longer be sustainable if rates move materially higher.

But market fundamentals are not all bad. “You have quite a unique combination of a more negative backdrop for risk taking in terms of monetary policy, but at the same time you still have a strong environment when it comes to earnings,” says Kokou Agbo Bloua, global head of cross-asset research at Societe Generale. “You can think of that as an earnings put that is behind the resilience of the equity markets.”

While the S&P 500 is down year-to-date, fourth-quarter earnings grew by 29% on average at the 56% of constituents that had reported as of February 4, according to FactSet.

As the macro environment begins to turn negative for stocks, the age-old clash between bulls and bears is playing out in a radically changed market that no one seems to fully understand. The events of January 24 may simply be a sign of things to come.