Nervous S&P 500 traders bet the market's best days are behind it

Even strategists lifting year-end targets warn of bumpy ride

The relentless rally in US equities has driven bears almost into extinction. But to say bullishness is ubiquitous would be a stretch.

From options trading to stock preferences to the direction of retail money flows, signs of trepidation are budding in a market where $27 trillion has been added to equity values in a little over a year.

A once-abandoned option trade that profits in a go-nowhere market is back in vogue, signaling caution. Funds that employ the strategy are receiving money at the fastest pace in nine years. And while reopening stocks roared ahead Friday thanks to positive jobs data, the retail-investor crowd have been losing their taste for the trade amid the spread of the delta virus variant.

Call them cautious bulls -- preparing for gloom, concerned about valuations, yet unwilling to completely bail. They’re hedging as growth slows and the Federal Reserve mulls rolling back monetary stimulus in a market that has gone nine months without a 5% pullback.

“Investors are nervously long,” Maneesh Deshpande, head of equity derivatives strategy at Barclays Plc, said by phone. “They see further equity upside to be limited.”

The tentative stance was on display as the S&P 500 Index climbed this week, extending a run of alternating gains and losses that began early last month. Over the stretch, defensive shares like utilities jumped to the top of market leaderboard, while energy, the darling of 2021’s cyclical trade, brought up the rear.

With the market stuck, selling options that are unlikely to get exercised is getting popular. Funds that use the strategy, known as buy-write, attracted $1 billion of fresh money in July, the biggest inflow since 2012, data compiled by Barclays show. That’s a reversal from the first six months of the year, when almost $2 billion was pulled out.

Traders using the buy-write tactic -- owning shares while selling options on them to generate premium income -- have been whipsawed in recent years as the equity rally sent calls into the money, reducing revenue from selling options.

The strategy works better during periods of higher volatility, when options are more expensive. Going by predictions from market handicappers, that’s the most likely current scenario to come. The average year-end target for the S&P 500 from strategists in the latest Bloomberg survey was 4,242, implying a 4% decline by December. While at least four of them have since raised their forecasts, the upgrades came with a dose of warning: get ready for turbulence.

David Kostin at Goldman Sachs Group Inc. just increased his projection to 4,700, tying with John Stoltzfus at Oppenheimer Asset Management as the most optimistic strategists tracked by Bloomberg. The journey to the new target, however, is “unlikely to be a smooth ride,” he warned.

“The path of the virus and its economic impact have proven difficult to predict,” Kostin wrote in a note earlier this week. “Later in the year, uncertainty around fiscal and monetary policy will likely drive volatility.”

Retail traders, among the first to embrace beaten-down airlines and cruise owners during the pandemic, are now taming optimism amid a spike in delta cases. Over the last two weeks, their buying of reopening stocks roughly halved from a month ago, according to data compiled by Vanda Research. Meanwhile, they snapped up shares of vaccine manufacturers and those that cater to stay-at-home demand.

Broadly, the drumbeat of warnings is getting louder. The proportion of newsletter writers classified in Investors Intelligence’s weekly survey as being in the camp calling for a market correction rose to 31% at the end of July, near the highest level since early 2020, data compiled by Yardeni Research show.

Macro headwinds aside, the chart can be seen as ominous. The S&P 500 has avoided a 5% drawback for 190 days. Granted, it’s a sign of resilience and could keep going -- the stretch through February 2018 lasted twice as long. What’s worrisome is the extreme velocity. The current episode, started in early November, has seen the index rising at an annualized pace of 46%, a feat never seen before, data compiled Susquehanna International Group and Bloomberg show.

To Chris Murphy, co-head of derivatives strategy at Susquehanna, the odds for some retrenchment have increased and investors should consider buying put spreads on the SPDR S&P 500 ETF Trust (ticker SPY) to hedge against potential losses.

“We typically see one or two 5% pullbacks every year, even during a bull market,” Murphy said. “And if things are even more sped up than has happened in the past, I would expect it as more likely that we’d be seeing one sometime soon.”