Costs to hedge the $16T S&P 500 rally rise ahead of Fed

Friday’s belated inflation reading cemented Wall Street bets that the Federal Reserve will cut rates at this week’s policy meeting. That doesn’t mean equity investors are sounding the all-clear.

A derivatives market measure of costs of bearish versus bullish bets has steepened as the S&P 500 Index trades near all-time highs. Investors who watched the index add $16 trillion in market value in the face of a series of dire warnings in the past six months have grown uneasy with President Donald Trump’s unpredictable trade-war threats, even as negotiators line up diplomatic wins for him and China’s Xi Jinping to unveil during meetings in Asia this week. 

Meanwhile, credit issues at some regional banks are triggering memories of Silicon Valley Bank’s collapse, and the future of the market’s AI euphoria will be put to the test with five megacap tech companies set to deliver earnings.

And even the Fed isn’t entirely a source of comfort. Officials have been flying blind when it comes to federal data since the government shut down Oct. 1, Friday’s consumer prices report notwithstanding. Private data shows an economy on ever-shakier footing, particularly when it comes to hiring. A spate of companies, from Target Corp. to General Motors Co. to Amazon.com Inc., have announced layoffs.

“Cracks in the rally are starting to emerge,” Stefano Pascale, Barclays Plc derivatives head, said by phone. “At the macro level, markets are becoming more concerned amid the re-emergence of tariff risks and a potential SVB crisis redux.”

So far, the stock market hasn’t shown much problem with all the risks. The S&P 500 rallied nearly 1% on Friday to cap a second week of gains. Trump’s tariff threats on Oct. 10 sparked a 2.7% rout was quickly reversed, with stocks on pace for a sixth straight monthly advance. 

Still, traders are bracing for more volatility, which has picked up sharply in October — generally the most turbulent time of year for indexes. The so-called VVIX Index, which measures the volatility of the Cboe Volatility Index, is nearly 5% above its two-decade average despite falling from its October peak. 

The Cboe SKEW index that measures the extra premium in short-dated, far-downside protection hovers near its highest level in two months, showing the implied volatility for bearish put contracts on the S&P 500 has climbed relative to calls.

“We may be borrowing from some future returns, so we’re being very careful and we’re holding onto an extra cash position as a hedge,” said Megan Horneman, chief investment officer at Verdence Capital Advisors LLC. She said Verdence has also used some liquid hedge funds to gain downside protection “because we do think this market is so overvalued.”

Warnings of a bubble have been most loud in parts of the market riding the AI wave, where surges in the Magnificent Seven megacaps, power companies and chipmakers have delivered tidy returns all year. Instead of ditching those winners, investors have bid up protection for a marketwide downturn.

That’s evident in the ratio of S&P 500 Index skew versus single-stock skew. While the former is in the top 76% percentile of observations going back 15 years ago, the latter is in the bottom 11th percentile of readings, according to data compiled by Barclays. The divergence between the two has hardly ever been this steep, and has only happened 10% of the time in the past 10 years, Pascale said.

Part of the reason for caution is the sheer number of potentially market-moving events lined up. While a Fed cut is a virtual lock, investors will pour over Chair Jerome Powell’s remarks for clues on officials’ thinking about the path for rates into next year. 

Some of the most-important corporate earnings will follow, with reports from Apple Inc., Amazon, Alphabet Inc., Meta Platforms Inc. and Microsoft Corp. — five of the biggest companies in the world that have been responsible for a huge portion of this year’s market gains.

Investors are “sitting on pins and needles,” waiting for information on AI spending and profitability, according to Brian Madden, chief investment officer at First Avenue Investment Counsel Inc. 

Yet FOMO-driven traders keep chasing technology shares, and that odd dynamic between single stocks skew versus equity indexes may, in turn, keep the broader rally chugging along — for now — amid higher volatility for single stocks.

“If earnings results from Big Tech are optimistic, that’s a renewed force that could trigger a new wave of upside chasing, which may widen the divergence between single stocks and indexes since some remain bullish on AI hopes and that macro risks will recede,” Barclays’ Pascale added. “But trade risks haven’t faded and will take a long time to resolve.”

‘Flying blind’

Among the risks are the lack of key data for investors and policymakers. Fed views on the economy are thus less informed and can lead to further market volatility for investors. 

“We’re kind of flying blind on macro data with the US government shutdown. We’re missing some critical pieces of the puzzle,” said Madden, who’s done some routine profit taking in a handful of stocks, particularly in the insurance sector, but isn’t moving large allocations to cash over macro risks at this point.

So far, the market continues to sail past the warnings. Friday brought renewed threats from Trump against Canada, and stocks barely noticed. Buyers continue to emerge at any sign of a pullback.

“You don’t want to be behind if you have a melt up,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group LLP. He’s seen higher-than-normal buying of macro hedges around both Friday’s consumer prices report and this week’s Asia-Pacific summit in the form of “classic” put spreads on the SPDR S&P 500 ETF Trust, or SPY — the largest exchange-traded fund tracking the broad equities index — as well as buying volatility.

At the same time, he said investors have been buying call spreads on the mega-cap tech names and especially the so-called Magnificent Seven tech companies, maintaining bullish positioning at a more company specific level. “If you can get past those two events,” Murphy said of the coming week’s macro risks, “then the market melts up to the end of the year.” 

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