The Stock Market is Doing So Well That We May Need to Start Worrying

Presently, the US stock market traders demonstrate an exceptional degree of fearlessness, prompting some strategists to brace for the possibility of a selloff.

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As of this year, the S&P 500 Index has experienced a substantial 19% increase, encouraging investors to actively engage in the market. In fact, traders' stock exposure has reached historically high levels, ranking in the top 28% of all recorded time, as indicated by Deutsche Bank's analysis of rules-based and discretionary strategies dating back to 2010.

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Interestingly, despite the potential risks, few traders appear concerned enough to hedge their positions. Protection against market downturns in the options market is currently at its most affordable level, according to Bank of America strategists in a recent note. The trading volume of call options, used to bet on the market's rise, has notably surpassed puts, reaching the highest difference since December 2021.

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Nevertheless, there are valid reasons to exercise caution. The Federal Reserve aims to engineer a soft landing after a period of inflation and intense rate hikes—an endeavor that historically encounters challenges. Moreover, based on historical trends, September and August have proven to be the two weakest months of the year for the S&P 500.

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As Jeffrey Hirsch, editor of the Stock Trader's Almanac, observes, the prevailing bullish sentiment and weak seasonality have triggered contrarian concerns. Notably, those who were bearish and remained on the sidelines are now chasing the market's momentum, while FOMO (fear of missing out) players have fully immersed themselves in the current market landscape, signaling a potential pause in the ongoing rally.

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The S&P 500's impressive surge has defied consensus expectations for losses at the beginning of 2023, leading many to reconsider their forecasts. Even some of Wall Street's most outspoken bears, such as Michael Kantrowitz of Piper Sandler & Co. and Mike Wilson of Morgan Stanley, have adjusted their stances.

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In response to the equity rally, traders have displayed a preference for calls in the options market, partly fueled by an AI-driven tech-stock surge. The volume of calls has outpaced puts by a significant margin across US exchanges, as per data.

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Certainly, the rally in the S&P 500 has been driven by several factors, including a gradual subsiding of inflation and the economy's relative resilience amid the most aggressive tightening cycle in decades. Consequently, Wall Street traders have eschewed downside protection, leading to a decline in the cost of hedging against potential drops to unprecedented lows.

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While the market's future trajectory remains uncertain, there are signs that momentum may be becoming overextended. The Cboe put-to-call ratio, which tracks options volume tied to individual stocks, is currently at its lowest level in over a year. Historically, this has translated into a period of flat performance for the stock market over the next three months, as per data compiled by Goldman Sachs Group Inc.

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Furthermore, seasonal patterns pose an additional challenge, as historical data from the past 30 years reveal that September and August have consistently been the two weakest months for the S&P 500.

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Luca Paolini, chief strategist at Pictet Asset Management, is one of many on Wall Street who recently closed a short position on US equities amid the relentless rally. While he is now neutral on US stocks, Paolini believes that investors are underestimating potential risks to the economy.

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The latest preliminary data showing an unexpected pickup in gross domestic product (GDP) for the second quarter has bolstered confidence in the economy, but it has also fueled speculation that the Federal Reserve's campaign against inflation could extend beyond initial expectations. Chair Jerome Powell emphasized the central bank's data-dependent approach to future interest-rate hikes.

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One potential concern relates to the easy year-over-year inflation comparisons, which may cease to provide the same positive outlook later in the year. Inflation swaps currently predict a 3.2% increase in headline inflation in July compared to a year ago and a 3.6% gain in August.

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This higher inflation rate could potentially delay any rate cuts by the Federal Reserve.

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Nitin Saksena, head of US equity derivatives research at Bank of America, warns of a prevailing "CPI-mission accomplished" mindset among many investors, highlighting that this may not accurately reflect the reality of the situation. There is a perceived risk that the Federal Reserve may keep interest rates higher for a more extended period, possibly leading to market disruptions in the future.

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