One of the strongest advocates for end-of-year bullish market flows that manifest in the form of a Santa Claus rally is Cem Karsan of Kai Volatility. He outlines three primary reasons why markets tend to climb into year-end, particularly after they have already been on a bull run through the first ten months of the year.
Coming into year end a recollateralization takes place, especially after the market has rallied in the first part of the year.
With the S&P 500 up by about 10% at the end of October and now almost 20% year-to-date, a substantial sum of money is likely to get re-invested at the start of 2024. The reasoning behind this is similar to the explanation behind why a Mom and Pop household who inherits a couple of million dollars puts it to work through some investment or other.
In the world of institutions and big money, when crunching the numbers, Karsan contends that a 10% gain on a $100 trillion equity market is approximately $10 trillion of new capital, and new collateral, that must be re-invested throughout the year.
It’s unclear quite how much goes to work on January 1 but even if it’s a small percentage of the total, such as 10-20% using conservative assumptions, that translates to $1 trillion in a world where $50 billion moves the market on a daily basis.
In short, a massive flow of capital should enter the market on January 1, which is a proxy for the first trading of the year, and that drives a massive Santa Claus rally in the last week of the year when funds attempt to front-run the influx of capital.
As a result of the inflows stemming from significant reinvestment, the first two weeks of the following year are usually also positive when the prior year has been bullish.
Karsan contends that if 2023 continues in the black as it’s on track to do, the recollateralization will be the most important driver to a year-end rally that continues through to mid-January of 2024.
The December expiration is the largest options expiration because it is tied to LEAPS that have been traded for years. A massive amount of open interest exists and options in strikes of this month are very broadly traded.
The end of the quarter options expiration features another high open interest period followed by January’s expiration, which has been the biggest expiration for end of year hedging since the launch of single stock equity options.
Open interest is extraordinarily high in the options traded during these expiration time frames and the skew is elevated too, so a much higher than normal positive decay occurs, which in turn creates vanna and charm flows driven off the skew.
Because of the distribution, the size of the positioning, and the high skew in those important expirations, the potential bullish energy is enormous.
High structured product issuances lead to volatility compression that cause many to ponder how the VIX can be so low when the market is up so much. Cem argues that the amount of structured product issuance is a key driver to low volatility, and is magnified by 0DTE (zero days to expiration) options, leading to low odds of a bigger vol event.
Absent a large tail event, which you could view as something akin to a 9-11 event, the bullish charm and vanna flows should continue to support markets.
A further bullish force is volume-weighted time that begins in the second week of November. There are fewer trading days heading into the final 7 weeks of the year as a result of Thanksgiving, Christmas and New Year’s holidays.
A lot of trading days feature lower volume and limited trading so, as a result of the actual number of days when trading occurs being dramatically lower by as much as 30% versus any other time of year, time-decay of options accelerates at a much faster rate compared to other times of year, which in turn accelerates charm and vanna flows.
Lastly, the big holidays of Thanksgiving and Christmas fall in the weeks following options expirations when vanna and charm flows are the least, meaning that an acceleration occurs during these periods of weakness.
The front-running tends to occur during these time windows also. As a result, there is a dramatic amount of flows exiting the options market that are probable and, on the other end of the spectrum, a recollateralization, creating a minimum of $1 trillion in flows during a two month period toward end of year.
The reality of these structured flows during this calendar period combine to create highly bullish forces that begin in the second week of November and continue through typically to the Wednesday prior to January options expiration, and contribute to a Santa Claus rally at year-end.
How Macro Flows Counter Bullish Flows
Karsan estimates that the bullish structured flows are, in actual fact, not $1 trillion but significantly higher. If you were to consider a 20% figure instead of 10% above, and factor in venture capital, growth equity, and private equity too, the number might be closer to $10 trillion.
He emphasizes that these are countered by macro flows, but they happen to be lower and hence don’t offset the bullish forces. By macro flows, you can consider capital fleeing the equity market to invest in short-term Treasury bills that yield a guaranteed return of circa 5% as well as bonds more generally.
If the other structured flows were not occurring, these bearish macro flows would be material, but they simply are not sufficient to derail the bullish thesis absent a tail-risk event.
It’s important for investors to note that these macro flows are likely to still be around when the more transient end-of-year bullish flows are in the rearview mirror.
Cem argues that turbulence in the REPO market and SOFR are evidence that liquidity is insufficient and the net result of higher issuances in the bond market as a result of ballooning debt will cause greater problems down the line, but not now. Any bear attempting to bet on those problems affecting the market now will be disappointed he believes. At the very least, he argues, wait until the bulk of the bullish forces have run their course by mid-January 2024.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.