Despite recent inflation data suggesting a potential interest rate cut by the Federal Reserve, investor confidence remains shaky. With unpredictable tariff threats from former President Trump, the looming possibility of a regional banking crisis, and the upcoming earnings reports from major technology firms, the cost of hedging against market declines has surged to notable levels.
Last Friday’s release of delayed inflation data bolstered Wall Street’s expectations for a rate cut at the Federal Reserve’s upcoming policy meeting. However, this anticipated shift in monetary policy has not alleviated the worries of equity investors. The S&P 500 index is hovering near record highs, but the indicators measuring the cost of bearish versus bullish contracts in the derivatives market are on the rise. Over the past six months, despite a string of alarming warnings, the market has seen an infusion of $16 trillion in market capitalization. Nevertheless, many investors are increasingly anxious about the unpredictability surrounding Trump’s trade war rhetoric.
In addition to trade concerns, potential credit issues looming over some regional banks are reminiscent of the earlier collapse of Silicon Valley Bank. As the market enjoys a wave of enthusiasm surrounding artificial intelligence (AI), the upcoming earnings reports from five major tech companies will serve as a crucial test for this optimism.
Even the Federal Reserve’s pronouncements are not fully reassuring. The absence of reliable federal data following the government shutdown has left officials scrambling to gauge the economy. Private sector data increasingly indicates a shaky economic foundation, particularly regarding hiring trends — a situation underscored by significant layoffs announced by companies including Target, General Motors, and Amazon.
“Cracks in the rally are beginning to show,” commented Stefano Pascale, head of derivatives at Barclays. “At the macro level, with tariff risks resurfacing and potential renewed crises, market fears are growing.” Despite these apprehensions, the stock market has shown resilience. The S&P 500’s near 1% rise last Friday marked its second consecutive weekly gain. Even a tariff threat issued by Trump on October 10, which briefly sent stocks tumbling by 2.7%, did not deter the momentum, with the market eyeing its sixth consecutive month of gains.
Despite this bullish performance, traders are preparing for increased volatility as October traditionally brings turbulence. Volatility indicators, such as the VVIX index, although slightly decreased from their October peak, remain significantly elevated. The Cboe SKEW Index, reflecting short-term downside protection costs, is near a two-month high, suggesting that implied volatility for S&P 500 put options is climbing relative to call options.
Investment strategies are adapting to this climate of caution. “We may be borrowing returns from the future, so we are being very cautious and holding extra cash positions as a hedge,” said Megan Horneman, chief investment officer at Verdence Capital Advisors LLC. She indicated the use of liquid hedge funds for downside protection, expressing concern that the current market may be overvalued.
Warnings of a valuation bubble are particularly evident in sectors that benefit from the AI boom, with significant gains seen among tech giants, electric utilities, and chip manufacturers. Rather than divesting from these sectors, investors are seeking protection against a broader market downturn, illustrated by the divergence between S&P 500 stock skewness and individual stock skewness.
Investor sentiment remains cautious, driven by a series of potentially market-altering events. As the likelihood of a Fed rate cut grows, market participants will be closely analyzing Chairman Powell’s commentary for insights into the future trajectory of interest rates. The forthcoming earnings reports from iconic companies like Apple, Amazon, Alphabet, Meta Platforms, and Microsoft are also creating anticipation. These five tech titans have been responsible for a significant share of this year’s market gains.
“Investors are on edge,” noted Brian Madden, Chief Investment Officer of First Avenue Investment Counsel Inc., as they await insights into AI investments and profitability. Despite this anxiety, a fear of missing out (FOMO) continues to drive traders to pursue tech stocks. The unusual dynamic between individual stock skewness and index skewness may maintain the market’s upward trend even amidst broader volatility, at least for the time being.
Should the tech giants report positive earnings, it could spark renewed momentum and buying activity, further widening the gap between individual stocks and broader indices. However, trade risks remain unresolved and are likely to persist.
A significant risk lies in the current lack of key data available to both investors and policymakers due to the government shutdown, which complicates the Fed’s ability to assess the economy accurately and may lead to increased market volatility.
As investors attempt to navigate this complex landscape, many continue to take profits in anticipation of turbulence while avoiding a full shift to cash, indicating a cautious yet prepared stance given the macroeconomic risks involved. Meanwhile, Trump’s latest tariff threats have not deterred stock purchases, hinting at a resilient investor sentiment that becomes pronounced during pullbacks.
“If there is a melt-up in the market, you definitely don’t want to be left behind,” remarked Chris Murphy, co-head of derivatives strategy at Susquehanna International Group LLP. He pointed out unusual macro hedging activities around CPI data releases and upcoming geopolitical summits. Investors seem to be placing bullish bets on the tech sector, anticipating that if they can weather the next few macroeconomic events, a surge in market performance could occur leading into the end of the year.
