In our 15 January note Equity Derivatives Weekly – Can’t fight the Fed we started the year with a short-term bullish bias due to: i) favourable liquidity conditions; ii) over pessimistic 4Q23 earnings revisions; and iii) a continued “buy-the-dip mentality” in the tech sector. Both European and US major indices have now reached the upper bound of their longer-term ascending channels, and prices historically tend to retrace from these levels with the only exception being during the dot.com bubble. The risk-reward is now more attractive to the downside, as a bearish negative divergence in the RSI has formed with the SP500 now closing 70 trading days without a pullback of more than 2%.
The participation has also been extremely narrow, with a handful of stocks driving the majority of the performance both in the SX5E and the SP500 with US momentum stocks reaching an RSI of 80, all while the market breath has been decreasing since the onset of the Santa Rally. This supports our expectation of a pullback in the short term. However, the risk to our thesis remains the ongoing Tech strength heading into Nvidia's earnings on 21 February. On the flipside. the markets’ excessive optimism on Nvidia ahead of earnings could reinforce a reversal should the expectations prove to have been overoptimistic leading up to the parabolic rise in its stock price.
Also supporting our expectation of short term pull back from current levels are the following: i) the recent outperformance of lower quality Memes and the most shorted stocks; ii) significant rise in equity fund flows; iii) excessive euphoria reflected in the options skew; and 4) a weakening impulse in liquidity. In addition, the US CPI data on the 13 February could pose risks to the downside as the one-week straddle on SPX costs only 1%, suggesting the asymmetry is to a CPI data surprise to the upside as underlying price pressures persist.
We close out our Mar 24 Calls at c.2x return on premium and propose April 24 390 puts costing 0.37% of spot.