(Bloomberg) — The S&P 500 index’s surprising 16 percent rally this year is rewarding traders who bought early and punishing skeptics. But the fear of failure remains.
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Investors can see this option in the market, otherwise it is becoming too expensive to foreclose. Contracts on a 10% decline in the SPDR S&P 500 ETF — the largest exchange-traded fund that tracks the index, better known by its ticker SPY — are 1.8 times higher than options on a 10% rally, according to data compiled by Bloomberg.
Although still shy of levels seen during the banking crisis earlier this year, it’s a sign that investors are starting to pay for protection heading into this week’s key reading on US consumer prices due out on Wednesday. That sets the stage for stocks ahead of the Federal Reserve’s interest rate decision on September 20 and Chairman Jerome Powell’s next press conference.
“The next rally in equities won’t come until we have confidence in price direction,” said Scott Ladner, chief investment officer at Horizon Investments.
Stocks were late, with the S&P posting losses of 3% in four of the past six weeks amid deep economic problems in Europe and China. Meanwhile, the latest CPI report showed inflation rose 3.6% year-on-year in August, up from 3.2% the month before.
Traders are betting the Fed will keep borrowing costs low in September, but expect another rate hike before the end of the year.
Given the strength of the market this year, hedging has largely been a losing strategy, forcing traders to trade stocks in a narrow band for months without a major downside and stop short of protection. As of Friday, 94 trading sessions have come and gone since late April without a single loss in the S&P 500 of at least 1.5% — the longest streak since 2018.
“It was exhausting,” said Peter Cecchini, director of research at Axonic Capital. “Enough people were wrong in this year’s rally that they are tired of spending money to hedge against future losses. But we don’t know how long the AI narrative can hold such high stakes.
Traders who don’t like the stability of volatility are taking advantage of the stability and taking cheap protection, said Scott Nations, president of Nations Index, an independent index of volatility and alternative strategies. In March 2020, the cost of protection was much cheaper than the volatility that preceded the pandemic sell-off.
The end of summer may mark a low point for the CBOE’s volatility index, better known as the VIX, which has mostly been below its long-term average this year. Goldman Sachs Group Inc. remains neutral on selling discount options linked to the S&P 500, as volatility tends to increase in September — a popular month when firms host more than 50 index-engineered analysis days, the firm said.
Of course, the S&P 500’s advance this year has forced many strategists to rethink their year-end forecasts for the index, as Wall Street’s consensus on expectations of a deficit in 2023 before it eventually resets. Despite the most intense tightening cycle of the past decade, the economy has remained relatively strong and inflation has slowed.
“If the economy remains strong and inflation eases further, it will continue to hurt strategists’ recession case,” said Chris Murphy, associate director of yield strategy at Susquehanna International Group. “I don’t see the economy collapsing.”
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