MW Wall Street's most frustrating 'pain trade' looks set to continue
By Joseph Adinolfi
Stocks poised to keep on rallying as the buy side gives chase, analysts at Nomura and Goldman Sachs say
For Wall Street's professional money managers, the biggest "pain trade" right now is the ongoing rally in stocks following a massively successful two-year bull run.
And there are plenty of reasons to expect that they will continue to climb as buy-side investors give chase, eager to catch up to benchmarks like the S&P 500 SPX, which, as of Tuesday morning in New York, has risen nearly 23% since the start of 2024, according to FactSet data.
That's according to Nomura's Charlie McElligott, who explained in commentary shared with MarketWatch on Monday how hedge funds, systematic traders, CTAs and other sophisticated investors have been so focused on protecting their portfolios against the risk of a selloff, that they have neglected to prepare for the "right tail" outcome - that is, an ongoing, powerful rally.
Elevated levels of the Cboe Volatility Index VIX, better known as Wall Street's "fear gauge," or the VIX, along with other gauges of demand for hedges like the skew on options tied to the SPDR S&P 500 ETF SPY, speak to this sense of caution, likely foisted on portfolio managers by their firms' risk-management officers. Given the myriad risks that could crop up to bulldoze stocks, and the two short-lived shocks stocks have endured in recent months, that's hardly a surprise.
Still, this cautious posture will drag on funds' performance, even as history suggests that forward returns for stocks up to one year later look pretty good when implied volatility - which is what the VIX aims to capture - is at or higher than it is right now, as the table below shows.
Even with the S&P 500 booking its 46th record close of the year on Monday, the VIX has remained notably elevated, hovering around 20, which is slightly above its long-term average, according to FactSet data. This unusual combination suggests many on Wall Street remain on edge about potential risks to the rally, most notably the upcoming U.S. presidential election.
According to Nomura's data, macro funds and long-short hedge funds have lagged the S&P 500 over the past three months, trailing the S&P 500 by 7.3 percentage points and 2.2 percentage points, respectively. This underperformance is fairly dramatic, relative to history, as the charts below suggest.
If stocks continue to climb, these firms, and others, will eventually be forced to chase the rally, likely through purchases of out-of-the-money calls (McElligott highlighted one notably large order for $615-strike SPY calls that hit Nomura's trading desk shortly before he fired off his latest missive to clients and the media).
'FOMU'
Analysts on a Goldman Sachs trading desk said in a recent note obtained by MarketWatch that the shift in buy-side firms' hedging activity described by McElligott has already started, as portfolio managers have shown more demand for upside calls. The team even coined a new acronym to describe this behavior: "FOMU" - or "fear of materially underperforming" an equity-market benchmark.
As far as Goldman Sachs is concerned, firms have good reason to give chase, given that flows into stocks from corporate buyers are expected to accelerate once most of the biggest U.S. companies exit their buyback blackout period later this month.
See also: Stock buyback programs have surged in popularity in 2024.
But that's not all. Households typically boost their purchases of stocks after a presidential election. And the expected decline in implied volatility once the vote has passed could encourage systematic funds and multi-manager pod shops to lever up their equity heading into the end of the year, given that November and December have historically been strong months for stock-market returns.
At the same time, the end of the fiscal year for mutual funds should cause tax-related selling pressure on some of the year's laggards to abate, the Goldman team said.
As old hedges expire worthless and traders open new bullish positions, options dealers would be forced to hedge their exposure by buying S&P 500 futures, pushing the market higher still. Eventually, systematic funds and CTAs - and even long-short discretionary managers - will be forced to boost their exposure to stocks, adding more fuel to the melt-up rally.
In Wall Street parlance, a "pain trade" occurs when the market takes an unexpected turn, leaving many professional money managers to play catch-up.
U.S. stocks were trading mixed on Tuesday, as both the S&P 500 and Dow Jones Industrial Average DJIA looked poised to pull back from Monday's record highs.
At the same time, the Nasdaq Composite COMP has climbed, as gains for Apple Inc. $(AAPL)$ and Google parent Alphabet Inc. $(GOOGL)$ offset a pullback in Nvidia Corp. $(NVDA)$, which notched its first record high in four months on Monday.
-Joseph Adinolfi
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(END) Dow Jones Newswires
October 15, 2024 10:39 ET (14:39 GMT)
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