Is The Tail Wagging The Dog?

April 14, 2025 - DJIA = 40,212 – S&P 500 = 5,363 – Nasdaq = 16,724

Is The Tail Wagging The Dog?

For a short time last week, it seemed that the storm was over and that the markets would return to their regularly scheduled programming!  President Trump announced a 90-day pause on the tariffs which triggered a historic stock market rally.  The S&P 500 had its 3rd largest one-day advance as there was hope for a resolution to the turbulence surrounding global trade.          
Of course, the Trump tariffs are the assigned cause for the markets’ disorder.  While the tariffs and the shifts within international commerce have a role, there are many other factors contributing to the commotion.  Obviously, an uncertain economic future and a changing business landscape are important pressures on the markets.  But there are several nonfundamental factors that are contributing to the market’s indigestion.  

The extreme concentration of market leadership, the stock market overvaluation, dealer flows, passive investing, and option trading are impacting the markets and have nothing to do with trade wars or other fundamental headlines.  Many investors do not realize that these structural market elements exist let alone their influence on the markets.  This is partially a function that sometimes they are not easy to calculate.  In some cases, the relationship between the mechanism and the market is not obvious.    

Everyone, even the most casual observer, is familiar with the term “Magnificent 7”.  These companies delivered amazing revenue and profit growth, and their stock prices responded with huge rallies.  As their share prices climbed more and more people bought them and they developed a cult following.  They have become so popular that many view them as members of the family.  

This kind of fame naturally encourages FOMO.  Institutional investors were not immune, and the Mag 7 stocks were stuffed into countless mutual funds and ETFs.  This desire to be at the party resulted in buying regardless of value which resulted in valuations that rival previous bubbles. 

The situation is that everyone owns the same stocks, and those stocks are severely overvalued.  While the Mag 7 kept climbing no one cared and no one in the financial media wanted to report on the risks of extreme concentration and valuation.  Now that uncertainty dominates the economy and markets, these risks become a problem.  

As funds and ETFs receive sell orders, they are forced to liquidate their holdings, which currently results in everyone selling the same positions at the same time.  In an environment that is as volatile as the present one, a large and quick plunge can happen whatever the headlines are.

Under this landscape, other underlying forces can add to the turmoil.  Such things as dealer positioning and zero days to expiration (0 DTE) option trading can dominate trading.  These two elements are interrelated and have expanded their role in recent years.  

Dealer positioning refers to firms that are market makers in securities trading.  Market makers are the firms that stand ready to buy and sell all types of stocks, bonds, futures, etc. at all times.  Their chief responsibility is to keep the market orderly and provide market liquidity.  They try to be neutral as it relates to the direction of the markets.    

Of course, in the process of trading with their clients, dealers can get offsides.  In other words, they can end up with a directional bias in their holdings.  When this happens, they must adjust their books through hedging whatever direction their risk is in.  If their holdings are net long, they may sell stocks, options or futures to get into a balanced position.  Similarly, they would buy stocks, options, or futures if they were net short.   

As dealers work through these adjustments, market makers might use 0 DTEs.  Also, their clients use 0 DTEs which complicates the dealers’ goal of remaining neutral.  This market sector is growing rapidly and 0 DTEs frequently are 50% of the volume of daily option trading.  As you can imagine, like a rush to liquidation, dealer flows, and dealer positioning can push the markets in a direction that is unexpected given a certain headline.  

With these elements, the markets can easily trade in a direction that ignores the news flow.  When these mysterious moves happen it’s almost a case where the tail is wagging the dog.