S&P and stocks so far this year: Turbulence behind the gains

Not everything in the stock market is as it seems.

A slowdown in inflation has boosted investor confidence in the economy this year and, combined with a strong enthusiasm for artificial intelligence, has provided the backdrop for a boom that has surpassed all expectations.

The S&P 500 has climbed 15 percent in the first half of 2024.

The rise has been remarkably steady, with the index rising or falling more than 2 percent in a single day only once. (It did rise.) A widely tracked measure of volatility is near its lowest level, raising bets on more volatility to come.

But looking below the surface shows a lot more turmoil. Nvidia, for example, whose soaring stock price helped it become America’s most valuable public company last week, is up more than 150 percent this year. It has also seen repeated massive declines over the past six months, shedding billions of dollars in market value each time.

More than 200 companies, or about 40 percent of the stocks in the index, are down at least 10 percent from their highs this year. Nearly 300 companies, or about 60 percent of the stocks in the index, are up more than 10 percent from their lows this year. And each group includes 65 companies that actually tilted either way.

Traders say the lack of correlated movement between individual stocks — known as dispersion — is historically extreme, undermining the idea that markets are in a state of calm.

One measure of it, an index from exchange operator Cboe Global Markets, shows the spread widened following the coronavirus pandemic, as tech stocks surged while shares of other companies tumbled. Analysts say it remains high, partly due to the staggering appreciation of a select few stocks at the cutting edge of AI.

This is presenting an opportunity for Wall Street, as investment funds and trading desks are engaging in spread trading, a strategy that typically uses derivatives to bet that volatility in the index will remain low while turbulence in individual stocks will remain high.

“It’s everywhere,” said Stephen Crewe, a longtime dispersion trader and partner at Fulcrum Asset Management. He believes these dynamics have surpassed even the most anticipated economic data in terms of importance to financial markets. “GDP or inflation data don’t matter at this point,” he said.

The risk for investors is that stocks will begin moving in the same direction again, together — most likely sparking a selloff that triggers a widespread selloff. When that happens, some fear that the roles of complex volatility trades could reverse and amplify the appearance of turbulence rather than mitigate it.

Estimating the total size of this type of trading is challenging even for those involved in the market, partly because there are so many ways to make this type of bet. Even in its most basic form, spread trading can involve many different financial products that are bought and sold for a variety of other reasons as well.

How big is it? “That’s a big question,” said Mr. Crewe.

But there are some signs. The options market has boomed – the number of contracts traded is set to exceed 12 billion this year, up from 7.5 billion in 2020, according to Cboe – and while there have always been specialists with derivatives strategies, mainstream fund managers are now said to be getting involved.

According to Morningstar Direct, assets held in mutual funds and exchange-traded funds trading options, including those trading dispersion, grew to more than $80 billion this year, up from about $20 billion at the end of 2019. And bankers who are offering clients a way to replicate sophisticated trades, but without expert knowledge, say they’ve seen a groundswell of interest in dispersion trading.

While its scope is not fully known, this alleged influx of money has raised comparisons to the last time volatility trading was popular in the years prior to 2018.

At the time, investors had crowded into options and leveraged exchange-traded products that promised big returns in muted markets but were susceptible to sharp sell-offs that increased volatility. These trades were explicitly “short volatility,” meaning they generated profits when volatility was low but suffered huge losses when the market turned turbulent.

So when the calm market suddenly turned turbulent in February 2018 and the S&P 500 fell 4.1 percent in a day, some funds were destroyed.

While this dynamic persists, analysts say it is far less significant and the advent of popular dispersal strategies is fundamentally different.

Because the trade attempts to profit from the difference between low index volatility and large fluctuations in a single stock, even in violent sell-offs the outcome is usually more balanced, with one part likely to increase in value while the other part is likely to decrease in value.

But even this generalization depends on how the trade was executed, and there are situations that could still get investors into trouble. This potential outcome is part of the reason spread trading is garnering so much attention right now – everything could be okay, but it’s very hard to know for sure, and what if it’s not okay?

“The firewood is very dry,” said Matt Smith, a fund manager at London-based asset manager Ruffer. “And there’s a lot going on in the world, so the weather is warm.”

Importantly, even the biggest companies in the market are scattered. Microsoft, which has capitalized on the AI ​​fervor, is up 20 percent this year. Tesla is down 20 percent. Nvidia remains isolated with a staggering gain.

So even on a day like Monday, when Nvidia fell 6.7 percent, the S&P 500 lost only 0.3 percent. The broad index was supported by other stocks, particularly other giant technology companies like Microsoft and Alphabet.

Despite a sharp decline in one of the index’s largest components, calm prevailed.

When all the big stocks start falling at once, as happened in 2022, the results can be painful. Dispersion trading can make it even worse.

According to industry experts, if a stock like Nvidia’s fall increases S&P 500 volatility, but losses are confined to tech or AI specific sectors, the asymmetric outcome will penalize many spread-out trades. Losses could mount as traders seek to cut their losses by making trades that increase volatility.

That possibility is hypothetical. Nvidia has yet to meet demand for its chips, and its earnings are steadily rising. Given these unusual market dynamics, the spreads could continue for some time, bankers and traders said.

But for some expert investors, who are more experienced with the complexities of trading spreads, the trade has lost its luster as it has been pushed to more extreme levels.

Naren Karanam, one of the biggest dispersion traders in the market who trades at hedge fund Millennium Partners, has reduced his activity given the diminished opportunity for profit, people with knowledge of his decision said. A rival hedge fund, Citadel, lost its head dispersion trader in January and chose not to replace the person.

Even some who remain in the market say that the current dynamics, in which volatility is so low at the index level and dispersion of individual stocks is so high, have left them with little desire to increase their trades. Others have begun to take the opposite side of the trade, to protect themselves from a tumultuous sell-off.

“Spreads can’t be too high, and volatility can’t be too low,” said Henry Schwartz, global head of client engagement at the CBOE.


Disclaimer : The content in this article is for educational and informational purposes only.

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