Like a slot machine paying off on every pull, the stock market’s most reliable bets lately have often been its riskiest.
Go long a company that sounds like something Elon Musk mentioned in a tweet (but wasn’t)? Signal Advance just soared 12-fold. Lend money to a software maker to buy Bitcoin? A Microstrategy convertible bond is up 50 per cent in four weeks (its option is in the money).
Throw a dart, hit a winner, so it has lately seemed. Emboldened by Federal Reserve stimulus, vaccines and the psychological conditioning that arises when no bad patch lasts, everyone from retail newbies to institutional managers is rushing to cash in on the 10-month-old meltup. Predicting exactly when such fevers will break is a near impossible task. But bubble warnings are starting to blare from every corner.
“It’s a full-blown mania, and the bull’s relative youth doesn’t make it ‘safer’ to climb aboard,” Doug Ramsey, Leuthold Group’s chief investment officer, wrote in a January 8 report to clients — which went on to note his firm has also been among the buyers.
Chasing momentum is working. Four days after ending the year at almost 40x earnings, the Nasdaq 100 Index posted its biggest rally in two months. Hedging against stocks, on the other hand, has been costly. A basket of favoured manager short positions went against them by 10 per cent last week, rallying the most in seven months.
“Too much froth, too much complacency,” said Matt Maley, the chief market strategist at Miller Tabak + Co, who thought last week’s spectacle in Washington would have at least slowed the frenzy. “After a 16 per cent rally in just two months and a 70 per cent rally since March, that news should have knocked down the market. A 10-15 per cent correction would be normal and healthy.”
Tesla’s ability to add 25 per cent to a market value of almost $700 billion over five days made headlines last week, but for real froth, the options market was the place to look. Calls expiring on January 15 with a strike price of $1,000, the most-traded Tesla option Friday, quintupled Friday, ending the week at $9.15 after starting at 53 cents each.
Individuals appear to be driving the action, according to JPMorgan Chase & Co, which cited a proxy for NYSE margin-account data indicating a potentially strong pickup in December versus previous months. Small-trader call option buying has snapped back violently after a seasonal dip in the last week in December, as has retail-oriented off-exchange trading, the bank says.
“Given the anticipation of further fiscal support, this force is likely to be sustained over the coming weeks,” strategists led by Nikolaos Panigirtzoglou wrote in a note Friday.
The industry has taken notice. Cboe Global Markets has been tailoring products to smaller investors. It refreshed mini S&P Index options to enhance liquidity and provide better execution for retail customers, after in June saying it would revive a mini-VIX product aimed at least partially at smaller traders.
The firm tried to “make some products that account for these changes in investor demand, which we believe is here to stay,” Arianne Criqui, Cboe’s head of derivatives and global client services, said in an interview in November.
Sundial Capital Research’s Jason Goepfert has been raising flags since the end of December over how big a force retail traders exert in the options market.
“By the looks of things, it’s gotten even worse,” Goepfert wrote in a note Tuesday. “The most reliable sentiment measures tend to be those that focus on real money and leveraged instruments. That’s when emotion has the greatest impact. When we look at some of the most leveraged vehicles available to investors, there is widespread evidence of extreme speculation.”
The market is primed for a rush into riskier holdings, given many assets like cash and bonds are offering historically depressed yields. Some investors have turned to stocks -- and options -- to generate the income that’s missing with almost everything else. Chris Murphy, a derivatives strategist at Susquehanna, noted in November that overwriting “can be a great way to enhance yields” given the combination of elevated volatility and high valuations.
Andy Nybo of Burton-Taylor International Consulting LLC also sees the hunt for yield contributing to the options frenzy.
“With bond yields at zero rates or very low rates, there’s a whole host of investors looking for yield enhancement,” he said in an October interview. “Options are a powerful tool not only for getting exposure but also a tool for earning yield for existing holders. So overwriting strategies, call writing strategies are all helpful tools for investors to earn yield as well as manage their risk exposure either on the upside or the downside.”
Saying there’s froth at the fringes is not the same thing as saying everything is doomed. In a note last week, strategists at Bank of America tried to plot all the signals pointing to a bear market in broader measures of stocks, and found 63% of them have been met. Among them are dwindling cash in fund holdings, an elevation in the Cboe Volatility Index and buoyant consumer sentiment. While the reading hit a three-month high, it’s short of the peak level of 79% seen in September 2018.
“Our checklist bear market signposts (signals typically triggered before an S&P 500 market peak) grew incrementally bearish,” strategists led by Savita Subramanian wrote. “Our 2021 forecast calls for muted S&P 500 returns.”