Stock-market investors expecting smoother sailing have history on their side

Stock-market investors expecting smoother sailing have history on their side

Stock market investors hoping for a breather after a brutally volatile 2022 have history — and options traders — on their side.

With a slowdown in inflation supporting speculation that the Federal Reserve is nearing the end of interest rate hikes, equity derivatives traders are expecting a respite from the turmoil that continued to roil markets last year. This has driven the so-called volatility curve – a plot showing expectations for the severity of price swings in the coming months – lower at any point than it was a year ago.

Other historical data also suggests that the optimism of the past two weeks is not misplaced. Among them: there have been only two consecutive annual stock market declines since 1950, during the recession of the early 1970s and after the bursting of the dot-com bubble earlier this century, which lasted three years. Nothing along these lines is expected in 2023, at least among the baseline scenarios from most Wall Street strategists.

“As bad as last year was, there’s so much bad news that it’s likely already baked into the markets,” said Ryan Detrick, chief market strategist at Carson Group. He thinks the US could avoid a recession, which would be a “huge positive catalyst” for stocks. “We are seeing steps in the right direction with inflation. That is the key to the whole puzzle.”

Of course, investors shouldn’t expect completely smooth sailing from here. In fact, January after a double-digit annual decline has historically been a difficult month for the S&P 500 Index.

However, 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 a month earlier and marked its smallest annual increase since October 2021. The data was widely seen as giving Fed officials room to to further reduce the pace of rate hikes in February. meeting

These stock market gains are welcome news for equity bulls as the S&P 500 posted a loss of more than 19% in 2022, the worst hit since the financial crisis of 2008. The good news is that years of downturns are usually followed by a rebound: The S&P 500 has pulled back from them by an average of 15% over the next 12 months, according to data since 1950 compiled by the Carson Group.

“Markets may have good reason to see the glass as half full on inflation and dismiss the central bank’s dodgy rhetoric,” said Emmanuel Cau, a strategist at Barclays Plc.

Still, there is reason for continued anxiety among stock investors, who pulled $2.6 billion from U.S. equity funds in the week to Jan. 11, according to a Citigroup Inc. note. citing EPFR Global data.

It is possible that the Fed may eventually defy market expectations. For example, officials are proving traders wrong when they predict interest rate cuts later this year. And the latest round of corporate earnings reports are just starting to come out, and they carry their own risks.

Those skeptical that January’s gains will hold can also point to precedent. In the four times that markets have posted double-digit declines in a year since the beginning of this century, stocks have fallen three times in the first month of the following year.

But for now, traders at least don’t expect any big blow. The two main economic reports of the month – employment figures and the consumer price index – have already been released and have shown that growth is holding steady and inflation is easing.

The Cboe VIX index — a gauge of anticipated price volatility in the S&P 500 that normally moves in the opposite direction of the index — ended last week at around 18, the lowest since last January.

Institutional investors have hedged their short equity bets in recent weeks and earlier this month increased their net position to the highest level since May 2022, Ned Davis Research’s analysis of CFTC data shows.

“If there’s a recession where it lasts for about two quarters, by the time we get to the second half of the year, the markets should be in a price recovery,” said Ed Clissold, chief US strategist at Ned Davis Research. “If the data on inflation continues to be favorable and earnings come in pretty well, you could argue that hedge funds will continue to cover their short positions, which would be pretty good fuel for continued growth.” .”

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