Despite the S&P 500 reaching a new record high last Friday, Goldman Sachs' trading desk has issued a warning that the rally has pushed the market to a tipping point for a correction. Goldman's US trading chief, John Flood, wrote in a weekend client note that the market "is starting to feel a bit overextended." When clients inquired about the reasons for the persistent market rise, Flood's core assessment pointed to a significant imbalance: total leverage remains excessively high, while net leverage is unusually low. He described this as the "perfect storm of right-tail risk we warned about at the March lows," which has been materializing over the past two weeks, with the fastest acceleration occurring last Friday. He further stated, "The market is now fully prepared for a pullback next week," referring to the current week. Simultaneously, geopolitical tensions escalated over the weekend. The Strait of Hormuz was closed again, driving Brent crude oil up by as much as 7.9% to $97.50 per barrel and WTI up over 7% to around $90 per barrel during Asian trading on Monday. S&P 500 futures fell 0.7%, while Nasdaq 100 futures dropped approximately 0.9%, putting immediate pressure on last week's gains.
The core of Flood's warning lies in the current leverage structure of the US market. According to Goldman Sachs Prime Brokerage data, the total leverage ratio across accounts is currently 310%, sitting at the 92nd percentile for the one-year range and the 98th percentile for the five-year range. This indicates that for 98% of the time over the past five years, market leverage was lower than current levels. Conversely, the net leverage ratio is only 75%, at the 21st percentile for the one-year range. High total leverage coupled with low net leverage suggests crowded market positioning but a lack of conviction in directional bets. This creates a scenario where pressure to deleverage could intensify rapidly if sentiment reverses.
Flood noted that from a purely technical perspective, the rally could potentially continue for some time, but only if the net leverage ratio rises above the 50th percentile of its one-year and five-year averages. However, there is still a significant gap to reach this threshold. Another driving force behind the recent gains, Commodity Trading Advisor (CTA) strategy funds, is also nearing its end. Flood reported that CTAs bought $33 billion in S&P 500 exposure this week and are projected to buy another $23 billion next week. However, he explicitly cautioned, "The peak velocity demand from this cohort is now behind us." This assessment was corroborated by Goldman trading desk colleague Brian Garrett in a Sunday evening report, who stated, "The two technical tailwinds of macro short covering and systematic CTA demand are concluding. The upcoming two weeks of earnings season will be the true test."
The outperformance of mega-cap technology stocks and the "Magnificent Seven" during this rebound has been notable. Garrett explained the mechanism behind this: "For every dollar of short covering in SPY/E-mini futures, there was a net purchase of 37 cents in the leading stocks." Over the past three weeks, the excess return of large-cap stocks relative to the equal-weight S&P 500 reached 133 basis points, representing one of the largest spreads in history. Concurrently, trading volume in call options for large-cap stocks is rising sharply.
Based on client conversations, Flood observed that genuine belief in the next leg of the AI-driven rally persists, with focus concentrated on energy, industrials, and hardware suppliers. Outside of AI, long interest is primarily centered in the healthcare sector. Additionally, hedge funds are gradually shifting from covering macro short hedges towards establishing long positions in individual stocks.
Another factor supporting the bullish case is the start of earnings season. Flood pointed out that Q1 earnings have begun on a solid footing overall. With companies representing 24% of the S&P 500's market capitalization set to report next week, the market will gain more directional signals. Furthermore, ETF trading volume has retreated to 30% of total volume, aligning with historical averages, after exceeding 40% in March. Market depth for the S&P 500 has also improved significantly, rebounding to $9 million from a low of $2 million last month, indicating better liquidity.
However, Garrett characterized the overall market environment cautiously: "This feels reminiscent of April 2025... this remains a very difficult market to navigate."
Alongside the correction warning, Flood and Garrett outlined five potential trading directions for the current environment: 1. **Long Emerging Market Equities**: Flood referenced a colleague's view on the Korean market, highlighting exceptional earnings growth expectations coupled with a low forward P/E ratio. The preferred US-listed instrument is EWY. Additionally, KWEB saw significant call option volume. 2. **Trade Tail Risk via Repriced Volatility**: The trading desk executed S&P 500 lookback put options, noting their cost is currently below pre-conflict levels and only slightly above the five-year average. 3. **Utilize Cheap Upside Volatility for Directional Views**: Bears could sell delta-heavy positions; bulls could hold right-tail options. Goldman models suggest further market gains could trigger significant gamma short exposure among market makers. 4. **Buy Calls on Short Squeeze Candidates**: The cost of call options on a basket of high-short-interest stocks is significantly lower than on a flagship index. 5. **Long Fertilizer-Related Trades**: Middle East conflicts are expected to disrupt fertilizer supply chains, potentially raising soft commodity costs next year. Goldman is pricing call options on a related index. Garrett suggested other "mid-cycle impact" opportunities exist, such as airlines versus jet fuel.
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