By: Steve Sosnick Chief Strategist at Interactive Brokers

There’s a strange preponderance of red on my screen today. It was something I saw quite often this year, but not so often lately. Yes, we still do have down days, and I’ll assert that they can be quite necessary. My concern is not about a minor downtick today, but a fear that investors have placed a huge parlay bet on the markets. The recent rally in equities implies that we will thread a very tight needle – that we will we be able to maintain solid earnings growth amidst moderating inflation that will occur with neither aggressive Fed action nor a recession. 

Can that happen? Sure. Is it likely to transpire in exactly that manner, well, that’s another story. There’s a reason that sports betting companies advertise parlays relentlessly. They have long odds against paying off, and the house is much more likely to price the odds effectively than the gambler. Yet this long-odds bet seems to be the base case at the moment.

First, a bit of perspective about today’s decline. The S&P 500 Index (SPX) has basically only given back its gains for the week, putting us back to the levels that we saw just as the final stage of an options-fueled ramp was taking hold late last Friday. Since the options activity was focused on SPY, we’ll use that as the basis for the 5-day chart below:

SPY, 5-Day Chart, 5-Minute Bars, August 11-17, 2022

(Click on image to enlarge)

Source: Interactive Brokers

There are solid rationales for today’s pause. For starters, UK inflation was dreadful, with a wide range of statistics coming in above expectations. It is becoming increasingly clear that Europe is suffering from increasing price pressures in a difficult economy.US investors are (were?) somewhat concerned about stagflation, but that seems to be the base case in Europe. A stagflating Europe and a stagnating China is not a great outlook for the world’s economy. It’s entirely possible that a weakening world economy can reduce demand sufficiently to cause inflation to moderate yet not cause a recession in the US, but that seems tricky at best. Certainly, the Treasury bond market doesn’t agree, since there is a 45 basis point inversion between 2- and 10-year yields. That is a classic recessionary signal.

It is also important to bear in mind that the most recent leg higher came after Chair Powell’s “neutral” comment at the post-FOMC press conference. Since then, various regional Fed Presidents and Governors pushed back against that “neutral” comment and reinforced the concept that rates hikes will remain in place. The question is not whether they will hike, but by how much. It will be interesting to see if the “neutral” concept made it into the minutes, or whether the Chair was speaking somewhat off the cuff at his press conference. We should also learn more about the plans for quantitative tightening, which should be accelerating in the coming weeks. Perhaps the minutes will point to better odds for the parlay, perhaps not.

Running a large options market-making book, which I did for decades, is not unlike being the house at a casino. Market makers tend to make a good portion of their money by selling options with high payoffs and low probabilities of success and then hedging them with cheaper alternatives. When casinos tout parlay bets, that is their hope as well.If the base case for the equity markets is a parlay, rather than a straightforward scenario, understand that the odds of success are much smaller than they seem.

More By This Author:

A Work-Around Or An End-Around?
Recycling The Playbook
Rate Of Change Vs. Value, CPI Edition