Investors are bracing for surge in market volatility
Bets on a rise in Wall Street’s fear gauge swell to most since March 2020.
Fear is creeping back into the stock market. To protect against a potential downturn, traders are scooping up hedges at the fastest clip since the onset of the Covid-19 pandemic.
More call options betting that the Cboe Volatility Index, or VIX, will rise have changed hands on an average day in February than at any time since March 2020, Cboe data shows.
After lying relatively dormant for months, the VIX, also known as Wall Street’s fear gauge, rose above 23 last week, its highest level since the first few trading days of the year. Readings below 20 typically signify complacency, while those above 30 signal investors are scurrying for protection.
The impetus for the increased demand is twofold. When stocks rebounded to kick off the year, investors piled back into the market, restoring their need to hedge their portfolios. More recently, a string of hot economic data increased the likelihood that the Federal Reserve will be forced to continue raising interest rates to bring inflation down, stalling the early-year stock rally.
The S&P 500 is coming off three consecutive weeks of declines, capped by Friday’s hotter-than-expected reading on the personal-consumption expenditures price index – the Fed’s preferred gauge of inflation. The stock benchmark is up just 3.4 per cent in 2023 – and down 5 per cent from its high on February 2.
In the coming days, investors will be parsing updates on consumer confidence and home prices, alongside quarterly earnings reports from Target and Salesforce for insight into the market’s trajectory.
“During the January rally, it looked like we were going to glide through a Fed tightening cycle without any damage to the real economy,” said Mike Edwards, deputy chief investment officer of Weiss Multi-Strategy Advisers, a New York-based investment-management firm. “Now, that certainty is fading more and more each day.”
Traders have finally come to grips with the Fed’s hawkish forecast on interest rates, but they are growing increasingly worried about where rates will ultimately peak. Derivatives markets show the federal-funds rate rising as high as 5.39 per cent in August, the loftiest level since the central bank began tightening last year.
Not only has the US economy remained strong, but the resiliency of the European economy and China’s reopening are helping reignite inflation concerns, Mr Edwards added. Revived risk of the Fed plunging the economy into a recession with more rate increases is boosting market volatility.
“Now people are asking, ‘Does the Fed need to break something?’” Mr Edwards said.
One of the biggest wagers tied to the VIX is for the index to hit 75 within the next month, a level only previously seen during stockmarket crashes. Another popular bet sees the VIX reaching 40 in the coming months, a level that hasn’t been breached since 2020.
Meanwhile, rekindled hedging demand has increased the cost of equity put options aiming to shield investors from a downturn in the S&P 500. Recently, those options reached their most expensive since October, per the Nations SkewDex, which tracks wagers against the SPDR S&P 500 exchange-traded fund that would pay out in the event of a large market decline. Put options give traders the right to sell shares at a stated price by a certain date. Call options grant the right to buy.
Investors’ foray back into stocks and the resurgence of volatility contrast with last year, when many of them battened down the hatches by paring their exposure to stocks or outright betting against the market. When optimism swelled at the start of 2023, investors – including model-driven quants, investment advisers and individual investors – were back in force.
Active investors recently turned up their equity allocations to the highest since April, according to the National Association of Active Investment Managers. Systematic investors – quant funds that follow rules-based strategies to ride market trends – also boosted their stock exposure to the highest since early 2021, Deutsche Bank data show.
Sentiment has fluctuated in recent weeks. Bullishness among individual investors reached its highest level since 2021 in early February, according to an American Association of Individual Investors survey. As of last week, that reversed to the most pessimistic in more than a month. Active managers have also headed for the exit doors.
Another sign of the exuberance among investors: Shades of meme-stock mania cropped up in the options market earlier this month. Traders exchanged bullish calls tied to megacap technology stocks at the highest levels in nearly a year.
“This is pure FOMO at its best,” wrote Mike Wilson – chief US equity strategist and chief investment officer for Morgan Stanley – of stocks’ rally last week. “In our view, we find all the hoopla and excitement about the [year-to-date] rally to be misplaced.”
The CME Group Volatility Index shows volatility in the Treasury market also recently reached its highest levels in more than a month. Fed officials have floated the idea of resuming 0.50-percentage-point interest-rate increases to cool the economy. The 10-year and two-year yields are sitting at 3.948 per cent and 4.803 per cent, respectively, marking the highest level since 2007 for the short-term yield.
Rising bond yields further threaten stocks, especially shares of the speculative and fast-growing companies that propelled the January rally. They have also helped cashlike products compete with stocks for investors’ attention.
Demand for short-term certificates of deposits – many boasting rates above 4 per cent – has risen to its highest since the 2008 financial crisis. Retail assets in money-market funds are hovering around record highs, Investment Company Institute and Federal Reserve data show.
Given the slimmed attractiveness of riskier bonds or stocks, investors are turning to cash to “extract as much juice as possible” from the market, said Ryan Weldon, portfolio manager at IFM Investors.
The Wall Street Journal
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