Year-end rally in US stocks approaching? Overly cautious investors may miss out on opportunities

According to the Zhitong Finance and Economics APP, investors who are most worried about things that have not happened yet may be caught off guard in the coming weeks. Due to investors paying higher prices for protection, the volatility of stocks, bonds, and currency options is rising. Risks are evident, such as the fiercely competitive U.S. presidential election, interest rate decisions in the U.S. and Europe, the escalating threat of conflict in the Middle East, and the upcoming earnings season. In the stock market, implied volatility exceeds actual volatility, making put options preferred over call options to guard against selling.

Nomura Securities' cross-asset strategist Charlie McElligott stated last week, "Risk management departments are forcing buyers to over-hedge due to a series of events happening simultaneously." "Investors everywhere are fixated on the 'worst-case scenario' left tail." He added that statistically, when such over-hedging occurs, the market always performs well, with the median stock market rising by 13% a year later.

Despite various indices hitting record highs, the volatility shock in early August is still fresh in memory. Market participants have not returned to the calm levels of the first half of this year, when hedge trades were seen as dragging down market performance. Trading overall is sluggish, with some investors even withdrawing funds: last week, the nominal value of open contracts for Nasdaq 100 index futures decreased by $5.7 billion in a single day.

However, if the market withstands the test of the November events and only produces ripples instead of a tsunami, traders may find themselves over-protected and under-exposed, leading to another situation of chasing the uptrend.

Issues with the performance of hedged portfolios have begun to surface: since August 5th, the downside hedging ETF for the S&P 500 by Invesco has fallen by 1.1%, while the total return of the SPDR S&P 500 ETF Trust Fund is 13%. When protection is lifted or has just expired, the counterparty dealer needing to adjust the trading book will increase buying.

Although the Chicago Board Options Exchange Volatility Index and other options cost indicators remain high, the one-month realized volatility of the S&P 500 index has dropped by more than half since mid-August, approaching a three-month low. Lower figures, especially after the intense volatility in early August is factored out, will attract systematic investors back into the market, creating another driving force. Nomura Securities estimates that this group alone may buy around $160 billion worth of stocks in the next three months

The wave of share buybacks by American companies is set to resume in less than two weeks, with billions of dollars worth of stocks being repurchased every day, adding another bullish sentiment. According to Birinyi Associates' estimates based on announcements from previous years, over $1 trillion in buybacks is expected to be completed in 2024 and 2025.

All of this could unfold in the final quarter of this year, when liquidity typically decreases and markets tend to rise.

Signs indicate that investors are preparing for an end-of-year rally. In the past week or so, traders have bought over 100,000 December $615 SPDR S&P 500 ETF call options, which are currently more than 5% above the market.

Scott Rubner, Managing Director and Strategy Specialist at Goldman Sachs Global Markets, wrote in a report to clients last week, "The selling in the stock market has been canceled, with institutional investors now forced to enter the market, clients shifting from left-tail hedging to right-tail hedging, and the year-end rebound starting to reverberate." He added that professional investors are increasingly concerned that their performance will significantly lag behind benchmarks.

Historically, from October 15th to the end of December, the median return of the S&P 500 index has been 5.2%. According to Goldman Sachs data, in election years, this number is only slightly higher at around 7%, implying a year-end level of 6,270 points. Bloomberg data shows that in nearly a century of data, only 25 years have seen negative returns in the fourth quarter.

While analysts expect a profit growth rate of only 4.3% in the third quarter, significantly lower than previous quarters, the overall tone of the U.S. earnings season is usually positive, with most banks reporting better-than-expected performance. Thomas Hayes, Chairman of investment firm Great Hill Capital, pointed out that the liquidity provided by the Federal Reserve has also strongly supported the stock market.

Hayes said, "This may be the first October of an election year with very limited volatility. Will we take a normal hit before the election, or will we just scrape by?"