There is a Massive Vibe Shift in the Markets, According to a Nomura Strategist. Here’s What Could Happen Next

On Wednesday, the S&P 500 index ($SPX) came tantalizingly close to setting a new all-time high. However, early signals point to a softer start for Thursday's trading session.

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On a positive note, Nomura strategist Charlie McElligott, renowned for his market foresight, has hinted at a potential "melt-up" in the markets. McElligott, known for accurately predicting the post-U.S. election rally and other key market moves, recently highlighted reversals in overcrowded trades involving a bullish U.S. dollar and bearish bond positions.

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In his latest analysis, McElligott points to what he describes as a “monster vibe shift” that has transitioned from macro trades to equities. He explains that the hedging of downside risks through bearish put options has now shifted toward a growing appetite for bullish call options on stocks. This repositioning in the options market could signal the potential for another rally in equities.

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Another factor that could contribute to upward momentum is the activity of volatility-controlled funds. McElligott estimates these funds may purchase as much as $40 billion in S&P 500 futures due to the recent decline in market volatility. Over the past month, prices have stabilized, and significant market swings have subsided, creating an environment more conducive to buying.

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Volatility-controlled funds are designed to minimize the impact of market fluctuations on portfolios. These funds tend to increase their stock exposure when the market becomes less volatile. McElligott notes that the five-day realized volatility of the S&P 500 has fallen from 22.2 to 8.7, effectively squeezing volatility to much lower levels.

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This shifting dynamic has spurred investor interest in several key themes, including Big Tech, artificial intelligence, and semiconductor stocks. Additionally, small-cap equities ($IWM) and gold ($GC00) have also garnered attention as part of this repositioning.

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While McElligott sees reasons for optimism, he also issues a cautionary note. He warns that the chase by volatility-controlled funds and other investors may introduce instability, potentially limiting further gains. Instead of a steady upward grind in the markets, this activity could lead to periods of heightened volatility and shakiness.

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As Thursday unfolds, stock futures have shown mixed signals. Futures tied to the S&P 500 ($ES00) and Nasdaq ($NQ00) are trading lower, particularly in the technology sector, while Dow Jones Industrial Average futures ($YM00) are inching higher. Meanwhile, the yield on the 10-year Treasury note ($TMUBMUSD10Y) is on the rise, currently sitting at 4.651%.

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In summary, while the S&P 500 flirts with record highs and market sentiment shows signs of improvement, caution remains warranted. The interplay between bullish repositioning and potential instability highlights the complexities of navigating the current market landscape. Investors will need to remain vigilant as these dynamics unfold.

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