The following is a guest post courtesy of Michael Kramer of Mott Capital Management.
Stock market volatility has picked up, and it may only be starting. Investors are eagerly awaiting the next FOMC meeting on January 26 to try and gauge which way the Fed may choose to go in its fight with inflation. With QE winding down, investors are now squarely focused on the potential for rate hikes and the unwind of the balance sheet.
The term structure of the S&P 500 shows there is a great deal of concern in the market and a heightened fear and is currently in backwardation. The SpotGamma Equity Hub models also indicate that the SPDR S&P 500 ETF (SPY) places the market on a slippery slope, which may only require the slightest nudge to get the markets rolling lower.
Nervousness
The term structure of the S&P 500 is clearly in backwardation until the middle of February when it begins to normalize. The message is that volatility is likely to remain exceptionally high going into the FOMC meeting next week and likely to remain that way for a couple of weeks to follow. The market has no idea what to expect out of the Fed at this point, and that is adding to this nervousness.
If the volatility is going to be high, investors may sell first and ask questions later. When fears get elevated, investors tend not to stand around, letting the market move without them. That little bit of extra fear may be the prod needed to get the markets rolling downhill.
Gamma and Technical Levels
The SpotGamma Equity Hub model shows there is a danger for the markets to start moving down. The SPY is nearing a steep drop, should selling pressure pick up heading into that FOMC meeting. The gamma models show that a drop below $455 on the SPY could quickly decline to $442. The model shows that the market should find some support between $434 to $442 as gamma levels off.
These gamma numbers are essential from a technical perspective because they represent significant technical support levels. In mid-October, the S&P 500 made a big move higher. A lot of that move happened after the Index gapped higher each day. The gap openings leave spaces on the chart, and over time, markets tend to “fill” those gaps by moving back to that price. The gamma level at $442 corresponds with a higher opening on October 15. That region on the chart should offer the Index some support should it fall there.
Rally Possible, Too
But not all is bad. Because of all the heightened volatility, circumstances could also prove to be very bullish, especially if the Fed should be more dovish. All of the market angst that has led to the higher implied volatility could unwind very quickly. This decline in implied volatility could result in a violent move higher for stocks, causing puts to lose value fast, resulting in Market Makers unwinding their hedges and adding fuel to the rally.
That makes this FOMC meeting of particular interest due to the risk that a policy announcement could have on rates and ultimately how equities respond.
The markets are likely to see a great deal of volatility over the next 2 weeks, where anything could be possible.
