(Bloomberg) —
Most read by Bloomberg
Judging by the ominous pronouncements of Wall Street luminaries, every trader under the sun should brace themselves for fresh turmoil in the world’s largest stock market.
But hedging against doom and gloom is quickly going out of style thanks to a historic stock market crisis that has already wiped out $13 trillion in market value this year and washed out both retail and institutional investors.
In the options market, the relative cost of contracts that pay off if the S&P 500 Index falls another 10% has fallen to its lowest level since 2017. The appetite for bullish betting is increasing. And the popular Cboe volatility index is well below multi-year highs even as equity benchmarks hit bear market lows.
All of this may sound strange considering the Federal Reserve is still poised to aggressively hike interest rates as well as recession risk snowballs. But traders get tired of reciting the same bearish mantras over and over again. Equity exposure has already been reduced to historic lows, while elevated inflation and tightening monetary policy pose few new threats.
“When there’s so much skepticism out there, maybe things aren’t so bad after all,” said Gary Bradshaw, portfolio manager at Hodges Capital Management in Dallas, Texas. “We’re awfully close to having priced in all the headwinds. The narrative repeats itself and traders are getting fed up.”
A sense of exhaustion, a low bar for good news and a higher bar for bad news help explain why the S&P 500’s slow slide appears to be producing fewer daily fireworks. Meanwhile, there has been an impulse of late to chase potential stock market gains into a historically strong season. During the rare sessions in which the S&P 500 actually gained in October, it posted an average gain of 2.4%, a move 1.8 times larger than the average decline for the month. It’s the widest ratio since October 2019, according to data compiled by Bloomberg.
The story goes on
This is not to say that traders are bullish. The VIX is still hovering near 30, reflecting expectations that stock prices will be more volatile than normal during these uncertain times. However, given historical inflation and the scary outlook for interest rates, it could be much higher. Cut-to-bone positioning is believed to reduce the need for bearish hedging. Systematic managers’ equity exposures, for example, are hovering near lows seen only twice in the last decade – during the European debt crisis and the March 2020 pandemic, according to Deutsche Bank AG.
With the cash on the sidelines, some investors are warming to the idea that most of the bad news is over and favorable seasonal patterns may yet come into play. Since 1990, the three-month period beginning Oct. 10 has given the S&P 500 a median gain of 7%, according to data compiled by Bespoke Investment Group. On an ongoing basis, this is the strongest three-month trading window for the entire year.
“The perception is that while we’re not there yet, we might be a step closer to finding the optimal floor,” said Steve Sosnick, chief strategist at Interactive Brokers LLC. “We have a healthy package of unknown unknowns, but after a 10-month run we might be closer to the solution.”
Nonetheless, a full-blown economic recession threatens to land next year and the Fed appears powerless to provide a dovish balance as in previous downturns. That’s why Chris Zaccarelli, chief investment officer at Independent Advisor Alliance, urges caution.
“A lot of people trading in this market are still using the buy-the-dip playbook,” he said in a phone interview. “It’s worked before, but inflation is a significant problem for the first time in 40 years and things are different.”
However, right now, panic attacks are hard to see in the options hedging world. Take the Cboe Skew Index, which tracks the out-of-the-money cost of S&P 500 options and reflects the demand for tail risk protection. The gauge has fallen in six of the past eight weeks, hitting the bottom decile of readings dating back to early 2010.
Meanwhile, there is little appetite to bet on a higher VIX by buying calls as the Cboe VVIX Index, a measure of gauge volatility, is floating at subdued levels. And more generally, there is increasing demand for bullish S&P 500 contracts versus downside protection.
“Customer demand is completely right-tail/crash-up focused,” wrote Charlie McElligott of Nomura Securities International Inc. in a note to clients. “They are afraid of missing out on the big rally if they don’t have/have enough underlying assets.”
–Assisted by Justina Lee.
Most Read by Bloomberg Businessweek
©2022 Bloomberg LP