Stock market investors hoping to catch their breath after a brutally volatile 2022 have history – and options traders – on their side.
With the slowdown in inflation supporting speculation that the Federal Reserve is nearing the end of interest rate hikes, equity-derivatives traders are hoping for a respite from the turmoil that has plagued the market for the past year. That left the so-called volatility curve — a plot showing expectations of the severity of price changes in the coming months — lower than a year ago.
Other historical data points also suggest that the optimism of the past two weeks was not misplaced. Among them: there are only two back-to-back annual stock-market drops since 1950, during the recession in the early 1970s and after the bursting of the dot-com bubble at the beginning of this century, which lasted three years. None of that is expected in 2023, at least not in the baseline scenario of most Wall Street strategists.
“With how bad last year was, there was a lot of bad news that may have priced into the market,” said Ryan Detrick, chief market strategist at Carson Group. He thinks the US can avoid a recession, which would be a “major positive catalyst” for stocks. “We’re seeing steps in the right direction with inflation. That’s the key to the whole puzzle.”
Of course, investors do not expect smooth sailing from here. In fact, January after its second annual slump in history was a tough month for the S&P 500 Index.
Still, the S&P 500 rose 2.7% last week and is up more than 4% for the year. On Thursday, the Labor Department reported that the consumer price index fell in December from the previous month and posted the smallest annual increase since October 2021. The data is widely seen as giving Fed officials room to reduce the rate of rate hikes in February. convene.
The stock market’s gains are welcome news for equity bulls after the S&P 500 posted a loss of more than 19% in 2022, its worst since the financial crisis of 2008. The good news is that down years are usually followed by a rebound: The S&P 500 has retreated from average -an average of 15% in the next 12 months, according to data since 1950 compiled by the Carson Group.
“Markets may have good reason to see the glass half full of inflation and dismiss hawkish” central bank rhetoric, said Emmanuel Cau, strategist at Barclays Plc.
However, there is still reason for concern among stock investors, who pulled $2.6 billion from US equity funds in the week to January 11, according to Citigroup Inc. which cites EPFR Global data.
It is possible that the Fed may finally defy market expectations. For example, officials pointed out that traders wrongly estimated interest rate cuts later this year. And the latest round of company earnings reports are just starting to be released and bring their own risks.
January’s gains that are skeptical it will continue may point to a precedent of its own. In the four occasions that the market has posted double-digit declines in the year since this century, stocks have fallen in the first month of the following year three times.
But for now, traders are at least expecting a major shock. The two main economic reports of the month – the employment figures and the consumer price index – have been released and show that growth has continued and inflation has eased.
The Cboe VIX index – a measure of predicted price swings in the S&P 500 that usually moves in the opposite direction of the index – ended last week at around 18, its lowest since last January.
Institutional investors have hedged their short equity bets in recent weeks and earlier this month increased their net-long positions to the highest since May 2022, an analysis of CFTC data by Ned Davis Research shows.
“If there is a recession that lasts for about two quarters, by the time we get to the second half of the year, the market should be priced to recover,” said Ed Clissold, US strategist at Ned Davis Research. “If there continues to be favorable inflation data and if earnings are good enough, you can make a case that hedge funds will continue to cover their short positions, which will be good fuel for the rally to continue.”
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