What Financial Markets Are Telling Us: Irrational Exuberance Will Win Out As Santa Claus Delivers

The volatility risk premium points to a higher market over the next few days, while my technical reading of key stocks in the S&P 500 is bullish. There are several negative factors across global asset classes. Gold is signalling inflation fears. The action in currencies signifies $US strength. The US yield curve is rising and in the current context that is bearish. Inflation expectations are rising based on measures of Treasuries and TIPS. But taken together, the market looks set to overcome these concerns and rise moderately over the next few days.

The market is fragile but impervious to the current newsflow as several trends are baked in: 1) we are learning to live with COVID and are giving up on herd immunity; 2) Europe and China are slowing but the leadership is stable and experienced so there little chance of further policy mistakes; 3) central banks are giving the bond and equity markets a put.

Consequently the volatility risk premium has turned bullish and further decline is likely to be a huge buying opportunity to play the seasonal Santa Claus rally. The broader derivatives markets confirm this: the volatility of volatility is persistently bullish while the SKEW index of fail tail risk shows continued hedging, meaning the bulls have a degree of protection and thus are more likely to deploy cash when the market corrects than to buy more protection. The volatility of bonds (TYVIX) is moribund as so many institutions have pulled out of active trading, while commodity futures point to a stagnant global economy with inflation pressures. Yet central banks have said they believe inflation to be transient and that translates into a put option for bonds and stocks. Consequently the latest rise in interest rates failed to breach earlier highs. With a central bank put investors are likely to buy into corrections rather than sell.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), Apple (AAPL), FedEx (FDX), Johnson & Johnson (JNJ), 3M (MMM), Pfizer (PFE) and a small net long position in S&P 500 (the levered inverse ETF SPXU and levered ETF UPRO).