Stock Market Fear Creeps Back as Hedging Costs Rise

The unexpected 16% surge in the S&P 500 Index this year has yielded gains for early investors while proving challenging for those who remained skeptical. However, apprehensions about a potential downturn persist.

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This apprehension is particularly evident in the options market, where the cost of hedging against another significant market decline is on the rise. According to data compiled by Bloomberg, contracts speculating on a 10% decline in the SPDR S&P 500 ETF, the largest exchange-traded fund tracking the index (commonly referred to as SPY), now command a price 1.8 times higher than options positioned to profit from a 10% upswing.

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While not reaching the levels observed earlier this year during the banking crisis, this uptick in hedging costs underscores that investors are increasingly willing to pay for protective measures in anticipation of the crucial reading on US consumer prices scheduled for release this week. This data will serve as a critical backdrop for market dynamics leading up to the Federal Reserve's interest-rate decision on September 20, along with Chair Jerome Powell's subsequent press conference.

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Scott Ladner, Chief Investment Officer at Horizon Investments, articulated, "The next significant phase of the equity rally is contingent on obtaining clarity regarding the trajectory of interest rates."

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Recent stock market performance has exhibited fluctuations, with the S&P 500 experiencing losses in four of the last six weeks, culminating in a nearly 3% decline. This decline has been driven by deepening economic challenges in Europe and China. Simultaneously, the forthcoming Consumer Price Index (CPI) report is anticipated to reveal a 3.6% annual inflation rate for August, up from the previous month's 3.2%.

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Traders are currently speculating that the Federal Reserve will maintain stable borrowing costs in September, yet they also anticipate a subsequent interest rate hike before the year concludes.

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Given the market's robust performance this year, hedging strategies have, for the most part, proven unprofitable. This has compelled traders to forgo downside protection, as stocks have remained within a narrow trading range for months without experiencing a significant decline. Up until Friday, a remarkable 94 trading sessions had transpired since late April without a single loss exceeding 1.5% in the S&P 500, marking the longest such streak since 2018.

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Peter Cecchini, Director of Research at Axonic Capital, commented, "There has been a sense of hedging fatigue among market participants. Enough individuals were incorrect about this year's market rally, leading them to grow weary of allocating resources toward guarding against potential future losses. Nonetheless, uncertainty looms over how much longer the narrative of artificial intelligence will be able to sustain broad market gains."

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Traders who remain unconvinced that the period of low volatility will persist are capitalizing on the current calmness to procure protection at a relatively lower cost. Scott Nations, President of Nations Indexes, an independent creator of volatility and option strategy indexes, pointed out that the expense associated with safeguarding against a resurgence in market volatility is currently close to its pre-pandemic levels in March 2020.

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As summer draws to a close, the CBOE volatility index, commonly known as the VIX, may hit a nadir. It has consistently lingered below its long-term average for the majority of this year. Goldman Sachs Group Inc. has adopted a neutral stance on selling put options linked to the S&P 500, as volatility typically picks up in September—an active month for companies hosting analyst days, with more than 50 such events scheduled, according to the firm.

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Certainly, the S&P 500's robust performance this year has defied the consensus expectations on Wall Street, which initially projected losses at the outset of 2023, followed by a subsequent rebound. This has necessitated a reassessment of year-end forecasts for the index by many strategists. Despite embarking on one of the most aggressive tightening cycles in decades, inflation has abated while the economy has exhibited resilience.

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Chris Murphy, Co-Head of Derivatives Strategy at Susquehanna International Group, observed, "If the economy maintains its strength and inflation continues to ease, it will challenge strategists' predictions of a looming recession. I do not foresee a major economic downturn on the horizon."

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