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Asset Management

What moves the market?

Konstantinos Pappas

13/10/2021

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The stock market is a complex system influenced by many uncoordinated decision makers. But correctly identifying the main market drivers can help you generate a winning trading strategy. So today we will go through the key variables you should account for when trading the S&P 500 index.

Interest rates

Interest rates changes (structural or not) have an immediate impact on the stock market. Any statement of the chairman of the FED following an FOMC (Federal Open Market Committee) meeting garners special attention from the investment public. Higher rates have a negative effect on valuations and earnings (with the exception of the financial sector).

Apart from the initial reaction to a change in the FED policy, rates have secondary slower effect on capital markets as they affects the real economy (borrowing-lending and spending-saving relationship change based on rates regiment).

The 10 year treasury and the 10 year-2 year rate spread are among key rates to track.

S&P 500 vs 10 year-2 year treasury rate spread
S&P 500 vs 10 year-2 year treasury rate spread

Market Sentiment

There are various sources (Twitter, Google Trends, Thomson Reuters Bloomberg, CNBC, etc ) that if correctly processed can provide a robust market sentiment aggregator. But in the of S&P 500 you can find quite representative sentiment signals from sources other than news.

VIX index

The most widely recognized and tracked measure of market volatility. VIX is based on the 30-day expected volatility of SPX call and put options.

VIX vs S&P 500 index
VIX vs S&P 500 index

Fear and Greed Index

A sentiment indicator provided by CNN based on (7 key variables, including VIX).

Fear Greed Index
Fear Greed Index

American Association of Individual Investors Sentiment Survey

A weekly survey gauging the mood of individual investors.

A.A.I.I. Survey Bullish percentage
A.A.I.I. Survey Bullish percentage

Investopedia Anxiety Index

A sentiment indicator based on the behavior of Investopedia readers (A reading of 100 is considered “neutral.”). A free alternative to those how do not have the resources to gather the sentiment of the investment community in the social media.

Investopedia Anxiety Index vs VIX
Investopedia Anxiety Index vs VIX

If you have access to the leading financial data providers you will also want to have a look at the readings of the Panic-Euphoria indicator provided by Citigroup and the Bull Bear indicator. An indicator that tracks fund flows provided Bank of America

Bull Bear Indicator Structure
Bull Bear Indicator Structure
Panic Euphoria Index
Panic Euphoria Index

Options market

Option market flows have a greater effect on market prices than you think (just ask the wallstreetbets community). Options on the S&P 500 index are among the most popular and widely used by investors. Therefore flows generated by the hedging activity influence the underlying market. Likely dealers delta hedging obligations, have a (relatively) predictable pattern. By tracking the implied volatility of S&P options we can have an idea of dealers market liquidity. Moreover the following the greeks values we can take advantage of flows that reinforce buying and selling sprees on the index.

Lets pause for a moment and refresh our greeks.

Delta is the ratio representing the change of derivatives price in comparison with the underlying. The 3 factors affecting Delta are:

  1. Gamma: change in delta with respect to underlying price,
  2. Vahna: change in delta with respect to in implied volatility),
  3. Charm (or Delta Decay): change in delta with respect to passage of time.

Gamma, Vahna and Charm Flows

The delta hedging activity creates gamma, vahna and charm flows in the underlying market. For example during a bullish market, high gamma exposure indicates support in the trend. The gamma flow is caused by dealers selling the rallies and buying the dips, reducing effectively the index volatility. As implied volatility falls and options expiration approaches, dealers will have to short less and less each day, providing vanna and charm flows that support the index price.

S&P 500 vs Index Gamma Exposure
S&P 500 vs Index Gamma Exposure

Effect of Options Expiration

Another important variable we have to take into account regarding option flows is Options Expiration (OpEx). For monthly option contracts, the expiration is the third Friday of each month. With the introduction of weekly options into the mix, we now have options that expire every single Friday.

The effects of vahna and charm are stronger during the second and third week (OpEx week) of the month and are slowly fading as we approach the middle of OpeX week. Note that VIX options expire on that day (Wednesday). After the OpeX the front month options expire and the the index is not subjected to hedging flows for around a week.

Effect of OpeX week on S&P 500
Effect of OpeX week on S&P 500

Although tracking market gamma vahna and exposure (as well as modeling their dynamic relation) is complex, they are quite accurate predictors of SPX movements.

Open interest and market put/call ratio are two more variables that can provide market sentiment indication. The put/call ratio calculated as the proportion of put option volume to call options volume purchased any given day.

Macroeconomic variables

There are many macroeconomic variables you could include in your model,most of them though do not seem to have a direct impact on S&P 500 (i.e.Money Supply, GDP). The market tends to reacts to surprises in key indices that affect the general economy like inflation, employment,and spending. So Inflation Consumer Price Index (CPI), Producer Price Index (PPI), as well as Employment and Consumer Spending and Confidence indexes, are the best candidates to include in your model.

Effect of inflation on S&P 500 returns
Effect of inflation on S&P 500 returns

In addition a useful index for those that have access is the Economic Surprise index offered by Citigroup.

Economic Surprise Index
Economic Surprise Index

Fundamental data

Price multiples (P/E,P/S as well its adjusted version CAPE provided by R.Shiller ), Forecasts(Forward P/E) and Earnings Growth are among the most followed fundamental indicators of the S&P index. These ratios have greater influence during earning season, as they offer insights on the strength of the market trend for the year. Furthermore, special attention should be placed on earnings growth and percentage of stocks beating analyst estimates.

Cyclically Adjusted PE ratio for S&P 500 Index
Cyclically Adjusted PE ratio for S&P 500 Index

However we should note that using valuation based on multiples may also introduce bias in your model. Just review the stock valuations back in April of 2020. Most of the ratios were admittedly infected with COVID.

Technical Indicators

The list of technical indicators is vast unlike their adaptation by the investment community (pun intended). Although their usefulness as trading signal is questionable. There are certain moving averages (200 day, 100 day, 50 day) that seem to gather special attention from market participants and can provide valuable trading signals

If you regard yourself as a market technician by any means add all the indicators that you swear by. However you should be careful on the noise you introduce in your model. You want to avoid averaging many indicators. along with the addition of many indicators with different time periods (i.e.100 days bollinger bands with 30 day MACD)  

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