Is there still room for the US stock market to rise? Nomura and Goldman Sachs both pointed out: Many traders will be forced to chase the rally!

For professional fund managers on Wall Street, the biggest "pain trade" at the moment is the continuous rise in stocks after experiencing a two-year bull market.

There are ample reasons to expect that, as buyers chase, stocks will continue to climb, eager to catch up with benchmark indices such as the S&P 500. According to FactSet data, as of Tuesday, the S&P 500 index has risen nearly 23% since the beginning of 2024.

This is according to Charlie McElligott, the strategist for Nomura Securities' global markets Americas business, who explained on Monday how hedge funds, systematic traders, CTAs, and other sophisticated investors are so focused on protecting their portfolios from selling risks that they overlook preparing for the "right tail" outcome, i.e., continued strong upward movement.

Indicators such as the Chicago Board Options Exchange Volatility Index (the "fear index" or VIX) and other measures of hedging demand, such as skewness of options related to the SPDR S&P 500 ETF, reflect this sentiment, which may be imposed on portfolio managers by risk management personnel at some asset management companies.

Given the numerous risks that could arise, as well as the two brief shocks that the US stock market has experienced in recent months, this is not surprising.

Nevertheless, this cautious stance will weigh on fund performance, even though history suggests that when implied volatility is at or above current levels, stocks' prospective returns in the next year look quite good.

Even as the S&P 500 index hit its 46th closing high of the year on Monday, the VIX remains significantly elevated, hovering around 20, slightly above its long-term average level, according to FactSet data. This unusual combination indicates that many on Wall Street are still uneasy about the potential risks of further gains, especially with the upcoming US presidential election.

According to Nomura Securities, macro funds and long-short hedge funds have lagged behind the S&P 500 index in the past three months, trailing by 7.3 percentage points and 2.2 percentage points, respectively. This degree of underperformance is quite significant compared to historical levels.

Nomura points out that if US stocks continue to rise, these companies and others may eventually be forced to chase the rise by buying out-of-the-money call options.

"FOMU"

Analysts at Goldman Sachs' trading desk stated in their latest report that buyer hedging activities have started to change as portfolio managers' demand for call options has increased. The team even coined a new acronym to describe this behavior: "FOMU," which stands for "Fear of Materially Underperforming" the stock market benchmark According to Goldman Sachs, companies have sufficient reasons to chase the rise of US stocks, as once the majority of large US companies end their buyback blackout period later this month, it is expected that funds from some corporate buyers will accelerate flowing into the stock market .

But that's not all. US households typically increase their purchases of stocks after a presidential election, considering that November and December have historically been strong months for stock market returns. Once the dust settles after the election, implied volatility is expected to decrease, which may encourage systematic funds and multi-fund management companies to increase their stock holdings before the end of the year.

The Goldman Sachs team stated that at the end of this fiscal year, mutual funds are expected to face reduced tax-related selling pressure.

As old hedging expires, traders will need to open new long positions. Options traders will be forced to hedge their exposure by buying S&P 500 index futures, further driving up US stocks.

Goldman Sachs pointed out that ultimately, systematic funds, CTAs, and even long-short discretionary fund managers will be forced to increase their exposure to stocks, adding more "fuel" to a "meltdown-style rise"