Investors laser-focused on the risks looming in the next few weeks may be left unprepared if their worst fears don’t come to pass.
Volatility is elevated for options on stocks, bonds and currencies alike as investors pay up for protection. The risks are clear: a hotly contested US election, interest-rate decisions in the US and Europe, the threat of a wider Middle East conflict and quarterly earnings. In the stock market, implied volatility is outpacing actual swings, and puts protecting against a selloff are favored over bullish calls.
“The buyside has been forced to over-hedge by risk management for a bunch of events occurring simultaneously,” Nomura cross-asset strategist Charlie McElligott said last week. “Investors everywhere are obsessing and fixated upon ‘Worst-Case Scenario’ left-tails.” Statistically, the market always performed well when said over-hedging occurs, with stocks on median up 13% a year later, he added.
With the volatility shock from early August still fresh despite indexes reaching record highs, market players haven’t returned to the level of calm seen in the first half of the year, when hedging was shunned as a drag on performance. Trading has overall been muted, and some investors have even pulled back: Open interest in futures for the Nasdaq 100 Index sank by $5.7 billion notional value in one day last week.
Yet if the market gets past the gauntlet of the November events with ripples rather than a tsunami, traders might find themselves with too much protection and too little exposure, leading to yet another episode of chasing a rally as it unfolds.
The underperformance of hedged portfolios is already playing out: Since Aug. 5, the Invesco S&P 500 Downside Hedge ETF is down 1.1%, compared with a total return of 13% for the SPDR S&P 500 ETF Trust. When the protection is unwound or just expires, dealers on the other side needing to adjust their trading books will add to the buying.
While the Cboe Volatility Index and other measures of options costs remain elevated, one-month S&P 500 realized volatility has fallen by more than half since mid-August to near a three-month low. The lower readings, especially as the wild swings from early August drop out of the calculations, are poised to bring systematic investors back into the market, creating another tailwind. That group alone could buy some $160 billion in stocks over the next three months, according to Nomura estimates.
Corporate buybacks in the US will resume in less than two weeks, adding another layer of bullish flow with billions in shares acquired every single day. Birinyi Associates estimates more than $1 trillion in repurchases will be completed in 2024 and 2025, based on announcements in previous years.
And all of that will potentially unfold in the last quarter of the year, when liquidity typically dries up and the the market tends to rise.
There are some signs emerging of investors starting to position for a year-end rally. Over the past week or so, traders bought more than 100,000 December $615 calls on the SPDR S&P 500 ETF — options currently more than 5% above the market.
“The equity market selloff is canceled, and a year-end rally is starting to resonate with clients shifting from hedging from the left-tail to the right-tail as institutional investors are getting forced into the market right now,” Scott Rubner, a managing director for global markets and tactical specialist at Goldman Sachs, wrote a note to clients last week. Professional investors are growing concerned about materially underperforming their benchmarks, he added.
From Oct. 15 through the end of December, the median S&P 500 return has been 5.2% historically. In election years, it’s been just over 7%, which would imply a year-end level of 6,270, according to Goldman. Out of the stock composite’s nearly century-long history, only 25 years had a negative return in the fourth quarter, data compiled by Bloomberg show.
While analysts are expecting just 4.3% profit growth for the third quarter — far below the previous periods — the US earnings season is off to a generally positive start, with banks for the most part reporting better-than-estimated results. Stocks are also well supported with central-bank liquidity, noted Thomas Hayes, chairman of investment firm Great Hill Capital.
“This could be the first October for an election year where we have seen very limited volatility,” Hayes said. “Do we get any of that normal chop pre-election, or do we just power through?”
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