"Risk-Averse Investors May Miss Year-End Rally in Stocks"

If the investors who are highly concerned about the risks that may emerge in the coming weeks are caught off guard by the fact that their worst fears do not materialize, it could be a surprise. The volatility of stock, bond, and currency options has risen as investors pay higher prices for protection. The risks are clear: interest rate decisions in the United States and Europe, the threat of expanding conflicts in the Middle East, and quarterly earnings. In the stock market, implied volatility has exceeded actual volatility, with put options to guard against selling being more favored than bullish call options.

Charlie McElligott, a cross-asset strategist at Nomura, said last week, "Risk departments are forcing buyers to over-hedge due to a series of concurrent events. Investors everywhere are obsessed with the 'worst-case' left tail." He added that statistically, when the above over-hedges occur, the market always performs well, with the median stock market increasing by 13% a year later.

Despite the indices reaching record highs, the memory of the volatility shock in early August is still fresh, and market participants have not yet returned to the calm levels of the first half of this year, when hedging transactions were seen as a drag on market performance. Trading is generally sluggish, and some investors have even withdrawn funds: last week, the notional value of open contracts for Nasdaq 100 index futures decreased by $5.7 billion in one day.

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However, if the market withstands the tests of events in November, only creating ripples rather than a tsunami, traders may find themselves overprotected and underexposed, leading to another situation of chasing the uptrend.

The issue of poor performance in hedging investment portfolios has already begun to emerge: since August 5th, the Invesco S&P 500 Downside Hedged ETF has fallen by 1.1%, while the total return of the SPDR S&P 500 ETF Trust is 13%. When protection is lifted or just expires, the other side of the traders who need to adjust their trading books will increase their buying.

Although the CBOE Volatility Index and other option cost indicators are still high, the one-month realized volatility of the S&P 500 has dropped by more than half since mid-August, approaching a three-month low. Lower data, especially after the violent fluctuations of early August are excluded from the calculation, will attract systematic investors back to the market, forming another driving force. According to Nomura's estimates, this group alone may buy about $160 billion worth of stocks in the next three months.

U.S. corporate buybacks will resume in less than two weeks, with billions of dollars of stocks being repurchased daily, adding another layer of bullish flow. According to announcements from previous years, Birinyi Associates estimates that more than $1 trillion in buybacks will be completed in 2024 and 2025.

All of this could unfold in the last quarter of this year, when liquidity usually dries up and markets tend to rise.

There are signs that investors are beginning to prepare for a year-end rebound. In the past week or so, traders have purchased more than 100,000 December 615 call options for the SPDR S&P 500 ETF, which are currently more than 5% above the market.Goldman Sachs Global Markets Managing Director and strategy expert Scott Rubner wrote in a report to clients last week: "The stock market sell-off has been canceled, as institutional investors are now forced to enter the market, clients shift from left-tail hedging to right-tail hedging, and the year-end rebound begins to resonate." He added that professional investors are increasingly worried that their benchmark performance is seriously lagging.

From October 15th to the end of December, the median return of the S&P 500 Index has historically been 5.2%. Data from Goldman Sachs shows that in election years, the index is only slightly above 7%, which means a year-end level of 6,270 points. Data compiled by Bloomberg shows that in the nearly century-long history of the S&P 500 Index, there have been only 25 instances where the stock market had negative returns in the fourth quarter.

Although analysts expect the profit growth rate for the third quarter to be only 4.3% - far below the previous quarters - the overall start of the U.S. earnings season has been positive, with most banks reporting better-than-expected results. Thomas Hayes, chairman of investment firm Great Hill Capital, pointed out that central bank liquidity has also strongly supported the stock market.

"This may be the first October of an election year where we see very limited volatility," Hayes said. "Will we take the normal hit before the election, or will we just barely get through it?"