The Market is Stressed Ahead of a Wild Week, Even Without a Shutdown

Investors have remained relatively composed amidst a recent stock market decline that has ushered the S&P 500 Index into its first losing quarter in a year. However, beneath this surface calm, indications of tension are emerging that extend beyond the narrowly avoided U.S. government shutdown.

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It is not the severity of the market downturn that is impacting sentiment, but rather the increasing frequency of significant declines coupled with a shortage of substantial rebounds. During the last quarter, three out of six days where the S&P 500 recorded losses exceeding 1% occurred since mid-September. Conversely, there were only two instances when the index registered gains exceeding 1%. This ratio of three down days to one up day is the highest seen since 1994, as reported by Bloomberg data.

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For those seeking solace in the expectation of a swift recovery, options traders are delivering a message: Do not become overly complacent just yet. A measure of expected price volatility in the S&P 500 Index for the upcoming week is currently higher than the anticipated volatility two months from now. This reversal of the usual pattern suggests that risks are perceived to be escalating with time.

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Several factors contribute to traders' unease as they approach the week. The looming threat of a narrowly averted U.S. government shutdown adds a layer of uncertainty. Additionally, the yield on the 10-year Treasury note hovers near its highest point in nearly 16 years, dampening the allure of riskier assets. Questions also arise concerning the Federal Reserve's willingness to combat inflation, and a deepening auto-worker strike further compounds the risk of more pronounced price swings in the future.

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Brian Donlin, an equity derivatives strategist at Stifel Nicolaus & Co., reflects on the current climate: "We just have a lot of questions that are on people’s minds. You’ve seen a bit more hedging, a bit more risk of a real vol spike."

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Trading activity remains orderly, and signs of panic hedging are scarce, even during a four-week-long decline in the S&P 500—the longest such streak this year—that has shaved off more than 5% from the index. Nevertheless, indications suggest that traders are bracing themselves for prolonged volatility.

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The cost of a "straddle" strategy, which bets on increased price fluctuations using options with the same strike price and expiration, now exceeds the average reading for a two-month period in various U.S.-focused exchange-traded funds, according to Stifel data from late September.

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Among those navigating this wave of volatility is Gareth Ryan of IUR Capital. A day after the Federal Reserve reaffirmed its commitment to a "higher-for-longer" stance, Ryan purchased a put spread on the SPDR S&P 500 ETF Trust, wagering on a decline in stock prices and a rise in volatility. He adjusted his position as the S&P rebounded on Thursday. The VIX Index currently stands at 17.52, surpassing its close of 14.11 from the evening before the rate-decision day.

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Nevertheless, this level still indicates a relatively low level of fear. Moreover, one characteristic of panic selling—synchronized share-price swings—is notably absent. The realized one-month correlation among S&P 500 stocks is at 0.24, down from 0.29 in late August, despite a broad market decline during that period. A shift from technology stocks to energy stocks has likely played a role in maintaining these low correlations.

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Bram Kaplan, head of Americas equity-derivatives strategy at JPMorgan Chase & Co., offers an assessment: "While investor anxiety may be rising, it is likely only doing so moderately and doesn’t feel like a panic. The rise in volatility is only moderate. There hasn’t been a surge in option volatility skew or the put/call ratio to indicate a scramble for hedges."

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Nonetheless, the latter part of September was less favorable for equity bulls. Rising concerns about interest rates have probably weighed on sentiment. Additionally, share buybacks have been halted for approximately 90% of S&P 500 companies due to a pre-earnings blackout, which has deprived the stock market of a significant upward force.

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The expanding strike by the United Auto Workers union against the Big Three automakers in Detroit and the potential government shutdown have only added to short-term uncertainties.

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This is why implied volatility for at-the-money S&P 500 options expiring in five days has fluctuated. At one point last week, these options hovered 0.7 points higher than a gauge measuring expected price swings two months from now, marking the widest spread since the banking crisis in March.

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The past few days have witnessed significant volatility, with short-term options reacting more sensitively to such fluctuations than longer-dated contracts. Data from Citigroup Inc.'s Stuart Kaiser illustrates how the VIX Index is more responsive to short-term S&P 500 moves and realized price swings in the index, compared to the volatility curve further out in time.

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Kaiser summarizes the current market condition: "The period of anxious but not delirious markets continues. We estimate the front of the VIX curve right in-line with market internals but room for futures to shift higher in a prolonged period of stress."

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