Melt-Up on the Mind as U.S. Stock Advance Hits Euphoria

(Bloomberg) -- U.S. stocks took the stairs during the six-month slog back from February’s market correction. Signs are mounting that investors expect them to ride the elevator even higher.

The S&P 500 Index has posted four straight all-time highs after Wednesday’s advance to gain 3.4 percent in the last 10 sessions alone, popping the benchmark above 2,900.

The surge pushed the gauge into overbought territory for the first time since Jan. 29 -- when market euphoria sent global equities into technically stretched waters ahead of a violent correction.

Market strategists don’t expect a repeat. Wall Street’s biggest cohort of bulls has ratcheted up estimates for where stocks end the year, with Barclays and Weeden & Co. now expecting the S&P 500 to hit 3,000 -- less than 3 percent above Wednesday’s close. That’d give the equity benchmark a 12 percent gain for the year.

The buy-side might play a major role in those predictions coming true.

The correlation between the S&P 500 and an index of hedge funds is near its weakest in the past five years, a sign that buy-side investors might feel pressure to boost their exposure to risk assets to avoid being left further behind.

Melt-Up, Redux

The ratio of bearish option bets to bullish ones is waning as the S&P 500 keeps churning out records. That implies investors may be loading up on derivatives as way to make up for lost ground should 2018 deliver a year-end rally similar to last year’s, when stocks closed with a 6.1 percent fourth-quarter surge.

And the dynamic playing out in the options market might just be getting started.

“Melt-up protection, that tends to happen really when you start to see new highs in the S&P,” said Maneesh Deshpande, head of U.S. equity and global derivatives strategy at Barclays. “Now we’re just getting there, so in my opinion I think the next few weeks are going to be key as we break out, that’s when you start to see a scramble.”

Buoyant appetite for call options may offer one explanation for why the Cboe Volatility Index, also known as the VIX or Wall Street’s fear gauge, rose in tandem with equities in recent sessions. A similar situation preceded the record spike in volatility earlier this year that abruptly ended the previous stretch of all-time highs for U.S. stocks. However, key differences suggest a precise repeat of that episode isn’t in the offing.

Positive Positioning

Other asset classes show speculators think markets will keep dancing to the risk-on beat. The weekly commitment of traders report points to significant bets that U.S. implied equity volatility and gold -- which tend to rise in periods of stress -- will fall, and that Treasury yields will rise.

Erin Browne, head of asset allocation for UBS Asset Management, explained why this fixed-income positioning helps contribute to a “pretty good backdrop” for risk assets.

“It makes it hard for global rates to materially break out to the upside given the fact that you have the Fed, which is now really going to have the debate, the discussion of when we get neutral, the ECB and the BOJ not being a positive catalyst for higher rates, and the market pretty short duration right now,” she said in an interview.

The speed of the advance in global equities over the past two weeks points to “some complacency in markets,” she warned, but even this seems largely justified given the improvement in the underlying economics and the low level of realized volatility.

Convergence

U.S. equities have pulled away from their global peers, but the rest of the world has started to narrow the gap.

Bright-eyed investors have cause to cheer a de-escalation of risk to the global economy that’s helped foster a rebound in overseas equities. Chinese policymakers have moved to push back against a potential disorderly depreciation of the yuan, Mexico and the U.S. have made progress on trade negotiations and the European economic surprise index has broken into positive territory for the first time since February.

Stateside, that’s helped materials, energy, and industrials -- cyclical sectors tied to global growth -- outperform over the past two weeks. All in all, it’s better for the sustainability of an advance for U.S. stocks to be in a flock rather than flying solo.

TINA Lives On

Even so, lingering external risks abroad and elevated expectations for the domestic economy mean the U.S. bull market -- now the longest on record -- has its fair share of detractors.

Early indicators show Chinese industrial activity continues to weaken. Italian debt still faces selling pressure ahead of a budget showdown with the European Union. Turkey’s problems haven’t disappeared, and the Brazilian real sank to its lowest level since January 2016.

David Bianco, chief investment officer at Deutsche Asset Management, thinks the next 5 percent move in U.S. stocks will be to the downside, citing those reasons.

“Dollar upside risk remains as the U.S. Federal Reserve intends to hike despite risks abroad,” he wrote in a note to investors.

There are also some signs investors still think stocks are the only game in town, with brokerage commissions falling even as U.S. stocks climb, according to Bank of America Merill Lynch. That implies retail investors are holding onto stocks at or near records instead of chasing the rising returns from short-term debt.

“There’s a clear polarization between the U.S. and the rest of the world, narrow market breadth in terms of FAANG stocks and little else, and long-term deflationary forces, which commissions are one sign of," said Jared Woodard, global investment strategist at BofA. “All that means that new highs in the U.S. market are great, but not great in terms of the prospects for more inflation and higher growth.”

Skepticism is warranted, according Cantor Fitzgerald global chief market strategist Peter Cecchini, but it’s tough to stand in the way of a market that’s steamrolling bears.

“The bottom line: market participants appear not to be buying arguments of peak earnings and care little about valuation (with the S&P trading at 2.2x revenue),” he writes. “Our stance must evolve with what U.S. equity market price action is telling us: i.e. - don’t fight the tape!”

--With assistance from Lu Wang, Cameron Crise and Sarah Ponczek.

To contact the reporter on this story: Luke Kawa in New York at lkawa@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Samuel Potter

©2018 Bloomberg L.P.