Hot Under the Collar

The Tail of the Tail of the Dog

Soundbite: Because of the size of the equity option market, it is often referred to as the tail that wags the dog, and that has never been truer than this week. JP Morgan has an enormous hedging program it offers to clients, revolving around five percent out-of-the-money puts that are purchased quarterly. The cost of that put insurance is reduced by assembling what is called a “put spread collar,” which involves selling a put twenty percent below the market and selling a call three to four percent above the market. The strikes act as magnets for the market because Wall Street option desks take the other side of the trade. Currently, the critical put strike level sits at 6475 in the S&P 500, and dealers are strapped with short put positions expiring tomorrow. This sets up potentially huge two-way intraday volatility, further complicated by quarter-end pension fund rebalancing.

Understand that over the next two days, if you see a sharp move in either direction, it may not be based on positive economic or better Iran news, but rather on mechanical buying and selling triggered by the expiration of 35,000 put option contracts and the quarterly rebalance.

Dealers have short-volatility positions that contributed to Friday’s relentless selloff as the S&P 500 plunged through the 6475 strike price. These dealers essentially have a long position that they need to hedge by selling S&P futures when the market falls. A good portion of that hedging has already been done. They will need to buy back those short futures hedges if the S&P returns toward that strike price. A sharp rally is possible thanks to stocks severely underperforming bonds during Q1 2026. The market will be supported by one of the largest stock-buying/bond-selling pension rebalances in years over the coming days.

A similar dynamic happened last year when the Liberation Day selloff pushed the S&P below the five percent put strike and forced dealers to sell into weakness into quarter end, exacerbating the downdraft culminating on April 7. Because the option expires Tuesday afternoon, the delta of the option (the odds of the contract expiring in-the-money) will swing from zero to one depending on how far away the S&P is trading from 6475. To complicate matters further, dealer positions are also affected by the impact of volatility and time decay.

Basically, be ready for anything this week.

PIK Me Up: The Sunny Side of Private Equity

Soundbite: We have been discussing private credit problems for months. Now, since that discussion is reaching a crescendo in the press, we want to examine whether the pendulum has swung too far in one direction, at least temporarily. The fear is understandable. Private credit is an opaque market that has grown to enormous size, and the headlines about defaults and redemptions are unsettling. That is why we raised concerns about potential systemic risks months ago. As we maintained, if the economy tips into recession, we could witness a full-blown bear market. Still, these loans are structured at the top of the capital structure and will be the first to recover over subordinated loan holders and certainly over equity owners; consequently, the ultimate losses could turn out to be manageable.

There are legitimate concerns over Payment-In-Kind (PIK) and Liquidity Management Exercises (LME), plus other financial engineering that masks potential defaults. However, private credit firms are senior creditors that have been conservative in the size of their lending, using metrics such as 30-40% loan-to-value ratios or capping the debt at 6x earnings of the portfolio companies. Direct private lending to software companies may be as high as $450 billion, and a portion of those loans were based on revenues with the hope that these portfolio companies eventually reach profitability. If the economy turns down in a recession, these negative cash flow companies could easily default. 

Importantly, there has been no significant increase in PIK activity nor in nonaccruals (borrowers classified as materially delinquent) over this period of increased paranoia.

To measure a true worst-case scenario, we can refer to the experience of the Global Financial Crisis, where the cumulative default rate in direct lending portfolios hit ten percent. Recoveries averaged approximately half the principal amount. That represented a system-wide hit of five to six percent. However, the coupons on these loans pay between nine and ten percent, so the nightmare scenarios may be a bit overdone. 

Goldman Sachs is obviously incentivized to paint an optimistic picture, but they have a point: the bad news hammering sentiment around direct lending for business development companies has largely originated elsewhere. The “cockroaches” spurring redemptions have emerged in structured credit and receivables financing, not in areas of private credit where most investors clamoring for redemptions are exposed.

Additionally, only one-fifth of direct lending private credit instruments have been sold to retail investors, who are the only ones that can redeem their investments. Therefore, eighty percent of assets that are sitting in these funds cannot be redeemed, meaning the fear of fire sales and a price spiral is not the base case. We anticipate fire sale headlines about individual funds that encounter liquidity problems, but thanks to that five percent redemption cap, there is a cushion at the fund level.

The downside of capping redemptions is that retail investors have been the main growth driver in private credit, and a good portion of that $230 billion may never return to the asset class. That capital outflow is problematic for borrowers like hyperscalers, who may face higher yields for their data center financing. For investors remaining in the private credit space, the situation represents an opportunity.

As lending spreads widen and terms improve, we would expect insider buying to materialize in publicly traded private equity and business development companies. Only then can we rest easy.

Weighing the Washout

Soundbite: Examples of the baby being thrown out with the bathwater are rampant in today’s equity markets. For example, the forward price-earnings ratio for the NASDAQ is 21x, a relatively attractive valuation given the NASDAQ’s superior tech growth expectations, compared to 20.5x for the S&P 500. Positions have experienced massive unwinds. CTAs have sold almost $200 billion longs this month, a liquidation only exceeded three times this decade: the selling climaxes of the volatility spike in January 2018, peak Fed tightening fear in December 2018, and the COVID collapse.

We are approaching fear markers generally seen near major market lows. Unfortunately, given the one-dimensional nature of this market, overwhelmingly focused on the price of crude, the geopolitical overhang makes this a special case, and one headline could push indices far lower.

Yet, there is a setup that is ripe for at least a bounce, and the contours of that bounce will tell us a lot about the intermediate-term direction of the stock market in this second year of the Presidential Cycle. Normally, prices trough into the midterms before experiencing a sharp bounce over the ensuing year.

Stretched we are:

• CBOE one-month correlations across the S&P 500 have risen to levels seen only twice since 2024: at the August 2024 and April 2025 lows.
• On Friday, the VIX traded above volatility priced three months out, an unusual occurrence last seen at the April and November 2025 lows.
• The CNN Fear & Greed Index failed to reach single digits, which normally marks a major low, but it hit 10, a level only seen eight times over the past 15 years, marking excellent buying opportunities.

The carnage has been evident in the NASDAQ, which has closed negative almost every week since January 5 this year, an extremely rare losing streak historically associated with major market lows. NVDA is the poster child for this selloff, trading at a similar valuation to the S&P 500 even though its growth this year is expected to account for over twenty percent of the entire index’s earnings growth. The Magnificent Seven ETF (MAGS) relative to SPY has retraced 61.8% of its outperformance from the April 7, 2025 lows through the October large-cap tech peak.

Given the extent of the selling, we are watching for positive divergences in some washed out areas relative to the broad indices as an early indicator of a market bottom.

What to Look for This Week

(All times E.S.T.)

1. Friday, April 3 at 8:30 a.m. March Nonfarm Payrolls. February’s -92k print was the lowest in four months, and further weakness will contradict Jerome Powell’s statement that January overshot on the upside, and February’s undershoot balanced out. Because December was revised down from 48K to -17K, it is imperative to see a number close to the 50k March consensus print. Another negative print would contradict the improving trend in Initial Claims. The Unemployment rate is expected to rise to 4.5% and the Average Hourly Earnings is forecast to fall to 3.4% from 3.8%, the lowest reading since May 2021.
   Tuesday, March 31 at 10:00 a.m. Jobs and Labor Turnover Survey for February.
   Wednesday, April 1 at 8:15 a.m. ADP National Employment Report for March
2. Wednesday, April 1 at 10:00 a.m. Institute for Supply Management Purchasing Managers Index for March. Our focus is on the Prices subcomponent, which spiked to 70, the highest level since June 2022. New Orders have been strong the past two months, so if they hold up in March despite the war, it will speak volumes. Friday, April 3 at 10:00 a.m. Non-manufacturing PMI for March. Its Prices subcomponent has leading tendencies for CPI and PCE inflation indices, and it peaked from July through October at 69, falling steadily to 63 into February.
3. Tuesday, March 31 at 7:50 p.m. Japan’s Tankan Large Manufacturers’ Index for Q1 Business Confidence. In his press conference, Governor Ueda mentioned that “Before the Middle East conflict, household and corporate activity had been firm. The government's stimulus measures will likely underpin the economy.” He made specific reference to the Tankan during his press conference last week to indicate if the Middle East crisis has had an impact. The Survey has been rising for three years, and the Q4 2025 reading was the highest level since Q4 2021. The release could sway policy into the April 27 Monetary Policy Meeting.

FOMC Voters Speaking: New York Federal Reserve President John Williams speaks on the economy on Monday, March 30 at 1:00 p.m. Tuesday, March 31 at 2:10 p.m. Vice-Chair Michelle Bowman gives her remarks on small business. That day, non-voter Austan Goolsbee speaks on March 31 at 9:00 a.m., followed by non-voter Alberto Musalem on April 1 at 6:05 a.m., where he discusses his views on the Economy and Monetary Policy. The two presidents of the Chicago and St. Louis Fed, respectively, do not have a direct impact on rates this year, but their comments could give us more color on FOMC consensus sentiment, especially if they agree with New York Fed President Williams.

Earnings: Tumbleweeds. Tuesday, March 31 Nike, Inc. (NKE) reports after market and perhaps we gain some insight into consumer behavior since the Middle East crisis. A smattering of gold companies report this week, including Americas Gold and Silver Corp. (USAS) on Monday, New Gold Inc. (NGD) on Tuesday, and NovaGold Resources Inc. (NG) on Wednesday, for those who celebrate.

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By Peter Corey

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