Volatility Rampant in Stock Market Where Optimism Still Abounds

(Bloomberg) -- The threats to the bullish case for stocks keep piling up.

Days after Congress all but ended its pursuit of a bipartisan Covid relief package, a lineup of Federal Reserve speakers warned that no new stimulus could doom the nascent economic recovery. The resurgent virus has sparked fresh restrictions in Europe, while the U.S. death toll topped 200,000 as investors speculate a vaccine remains months away.

The troubles -- none of them exactly new -- conspired Wednesday to spark a selloff that wiped $650 billion from American equities. The S&P 500 fell 2.4% to the lowest since July, while the Nasdaq 100 lost 3.2% and is on track for its second-most volatile month in 18 years by one measure.

“It’s a volatile trade right now because the market is trying to digest the incoming data, prospects for a vaccine -- there’s a lot of moving parts,” said Candice Bangsund, portfolio manager of global asset allocation at Fiera Capital Corp. “The re-emergence of volatility and more erratic trading conditions have been consistent with what we believe will be a choppy market environment between now and the U.S. elections in November.”

Calm has been absent from U.S. markets all month after stocks posted the biggest August rally since 1986. The Nasdaq 100 is down almost 13% from its Sept. 2 record and the S&P 500 briefly fell into a correction on Monday. Yet for all the selling, optimism still abounds in corners of the market, sounding another warning for some strategists.

Take options, where a measure of bearish bets relative to bullish ones remains stuck below its historic mean. Historically, during prolonged bouts of selling, investors pile into puts that protect against further downturns. That hasn’t happened so far this month.

Nor has investor sentiment soured. A gauge of optimism compiled by Ned Davis Research is hovering near 35. In the five most recent pullbacks of at least 10%, the measure slid below 30.

Together the relentless bullishness is a sign that the selloff has further to go, according to Ed Clissold, chief U.S. strategist at the firm.

“The extreme option optimism has not been reversed,” Clissold wrote in a note to clients. “Additional pessimism may be needed to wash out the bulls after a powerful five-month rally.”

Retail traders, key drivers of the options market during last month’s rally, have also shown persistence in the face of the selloff. The smallest of traders last week increased their bets on a surge, Options Clearing Corp. data compiled by Sundial Capital Research show.

The group boosted bullish call buying to 48% of total volume in that period even after experiencing losses earlier this month that Sundial President Jason Goepfert characterized as likely “catastrophic.” It was such rampant near-term call buying by retail traders that exacerbated the August rally and the subsequent selloff.

There are other signs that speculative activity remains elevated. The largest exchange-traded fund that tracks the Nasdaq 100 Index saw its total open interest rise to 10 million contracts at the end of last week, the highest since 2007.

The 10-day moving average of the Cboe equity put-to-call ratio fell to a 20-year low of 0.42 at the start of this month. While it’s since climbed to 0.55, it’s still 10 basis points below its mean over the stretch.

Buttressing the sentiment is accommodative monetary policy from the Federal Reserve. But to Matt Maley, chief market strategist at Miller Tabak + Co, a loss of a bigger magnitude is probably needed.

“Whenever the stock market sees a strong (pretty much uninterrupted) rally that takes the market to an overbought and overvalued level, it usually takes two declines to take a lot of the bullishness/complacency/froth out of the market,” Maley said in a note. “In other words, it usually takes a ‘failed rally,’ one that burns the ‘buy on weakness’ crowd in a more material way than they’re used to in order to create some real fear in the market place.”

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