Not everything is as it seems on the stock market.
A slowdown in inflation has boosted investor confidence in the economy this year and, along with strong enthusiasm for artificial intelligence, has set the stage for a rally that has exceeded all expectations.
The S&P 500 climbed around 15 percent in the first half of 2024, further climbing into record territory.
The gains have been remarkably stable, with the index only once rising or falling by more than 2 percent in a single day. (It’s up.) A widely followed measure of bets on more volatility going forward is near its lowest level ever.
But a look beneath the surface reveals much greater turbulence. Nvidia, for example, whose soaring stock price helped it become the most valuable publicly traded company in America last week, is up more than 150 percent this year. The price has There have been repeated deep declines in the last six months, each time losing billions of dollars in market value.
More than 200 companies, i.e. around 40 percent of the stocks in the index, are at least 10 percent below their annual high. Almost 300 companies, around 60 percent of the index, are more than 10 percent above their annual low. And each group includes 65 companies that have actually pivoted in both directions.
Traders say this lack of correlated moves – known as dispersion – between individual stocks is reaching a historic extreme and undermining the idea that markets have been characterized by calm.
One measure of this, an index from exchange operator Cboe Global Markets, shows that dispersion increased in the wake of the coronavirus pandemic as technology stocks soared while shares of other companies suffered. Analysts say it has remained high, partly due to the astonishing rise in value of some select stocks on the cutting edge of AI.
This represents an opportunity for Wall Street as mutual funds and trading desks focus on dispersion trading, a strategy that typically uses derivatives to bet that index volatility will remain low while turbulence in individual stocks remains high.
“It’s everywhere,” said Stephen Crewe, a longtime dispersions trader and partner at Fulcrum Asset Management. He believes that this dynamic has surpassed even the most anticipated economic data in terms of its importance for financial markets. “GDP or inflation data play almost no role at the moment,” he added.
The risk for investors is that stocks suddenly move back in the same direction – most likely due to a spark that triggers widespread selling. If that happens, some fear, the role of complex volatility trades could be reversed, exacerbating rather than dampening the emergence of turbulence.
The dispersion trade.
Estimating the total size of this type of trade is challenging even for those operating in the market, in part because there are multiple ways to make such a bet. Even in its simplest form, dispersion trading can involve several different financial products that are also bought and sold for several other reasons.
How big is it? “It’s a million-dollar question,” Mr. Crewe said.
But there are some clues. The options market has exploded – the number of contracts traded is expected to exceed 12 billion this year, according to Cboe, up from 7.5 billion in 2020 – and while there have always been specialists with strange derivative strategies, it is now said that there are more mainstream Fund manager admits to accumulating.
Assets in mutual funds and exchange-traded funds that trade options, including trading diversification, rose to more than $80 billion this year, from about $20 billion at the end of 2019, according to Morningstar Direct. And bankers who provide the opportunity to their customers Those seeking to recreate sophisticated trades but without the relevant expertise say they are seeing growing interest in dispersal trading.
While its extent is not fully known, this perceived inflow of funds has drawn comparisons to the last period when volatility trading became popular in the years leading up to 2018.
Back then, investors had piled into options and leveraged exchange-traded products, which delivered high returns in subdued markets but were highly vulnerable to sharp sell-offs that increased volatility. These trades were explicitly “short volatility trades,” meaning that they profited when volatility fell but lost heavily when the market became turbulent.
So when the markets suddenly calmed down in February 2018 and the S&P 500 fell 4.1 percent in one day, some funds were wiped out.
While this dynamic continues, analysts say it is much less significant and that the adoption of popular diversification strategies is fundamentally different.
Because trading seeks to profit from the difference between low index volatility and significant swings in individual stocks, even in a sharp selloff the outcome is usually more balanced, with one portion likely to increase in value while the other declines.
But even this generalization depends on how the trade was executed, and there are circumstances that could still get investors into trouble. This possible outcome is one of the reasons dispersal trading is getting so much attention right now – anything could be good, but it’s very hard to know for sure, and what if it isn’t?
“The firewood is very, very dry,” said Matt Smith, fund manager at Ruffer, a London-based asset manager. “And there’s a lot going on in the world, so the weather is hot.”
The detente could be ugly.
What is crucial is that even the very largest companies are scattered across the market. Microsoft, a beneficiary of the AI craze, is up 20 percent this year. Tesla is down 20 percent. Nvidia remains the outlier with astonishing growth.
Even on a day like Monday, when Nvidia fell 6.7 percent, the S&P 500 only fell 0.3 percent. The broad index was supported by other stocks, particularly other giant technology companies such as Microsoft and Alphabet.
Despite the sharp decline in one of the largest index components, calm appeared to prevail.
If the big stocks all start to fall together, as they did in 2022, the result could be painful. Dispersal trading could make things worse.
If S&P 500 volatility spikes because a stock like Nvidia collapses, but the damage is limited to technology or AI-specific sectors, an asymmetric outcome would penalize many diversified trades, according to industry experts. Losses could skyrocket if traders looking to limit their losses make trades that exacerbate volatility.
This possibility is hypothetical. Nvidia hasn’t yet met demand for its chips and its profits continue to skyrocket. Given these unusual market dynamics, the spread could continue for some time, bankers and traders said.
But for some specialized investors who have more experience with the complexities of trading diversification, trading has lost its luster as it has been pushed to ever more extreme levels.
Naren Karanam, one of the market’s largest dispersion traders who plies his trade at hedge fund Millennium Management, has scaled back his activities as he sees fewer opportunities to make profits, people familiar with his decision said. A rival hedge fund, Citadel, lost its top dispersion trader in January and chose not to replace the person.
Even some still in the market say the extreme current dynamics, with index-level volatility so low and individual stock dispersion so high, leave them with little appetite to expand their trading. Others have begun to take the opposite side of the trade and hedge against a turbulent selloff.
“The spread can’t be much higher and the volatility can’t be much lower,” said Henry Schwartz, global head of client engagement at Cboe. “There is a limit.”
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2024-06-28 16:17:40
www.nytimes.com
