S&P 500 Index (SPX): The Next Vol Shock Maybe Brewing

The SPX is being driven higher by speculative momentum chasing, with a dwindling number of mega cap stocks supporting the advance. Retail investors appear to be panic buying in both individual growth stocks and options markets, with little appetite for downside protection. These are similar conditions to those seen just prior to previous volatility shocks that gave rise to sudden sharp market declines and marked the early stages of bear markets. With markets priced for perfection, even the slightest weakness in equity prices could lead to spiralling losses.

Momentum Stocks Have Been Panic Bought

As the first chart shows, just 5 stocks led by Nvidia (NVDA) have been responsible for 75% of the gains seen in the S&P500 since the start of the year, rising by an average of 30% and adding $1.5trn in market cap to the index. That is, the same market cap as the lower 121 stocks in the index and more than the entire S&P600 Small Cap Index.

In percentage terms, AI play Super Micro Computer’s (SMCI) advance has made Nvidia’s gains look small, rising 3.5x since the start of the year. Its Relative Strength Index is now at 97 out of 100.

This widespread optimism is joined by a sense of complacency in options markets. After a brief spike to 18 on Monday the VIX is back at 14, while the SDEX skew index remains near record lows suggesting that very few participants are hedged for a reversal in recent gains. We have also seen a surge in google search data for “call options” since the start of the year, and when combined with the rise in 1-lot SPX options, this paints a picture of retail investors panic buying upside.

The next chart shows the product of the SPX dividend yield and the VIX as a way of highlighting the complacency in the market. The figure has only been lower on three previous occasions which were the very peak of the market in July 2000, the beginning of 2007 just prior to the global financial crisis, and January 2018 which preceded the ‘Volmageddon’ VIX spike and a 12% market pullback.

Strong Growth And Rate Cuts Cannot Justify These Valuations

Speculative activity has driven up valuations to near record levels. As I argued here, the SPX is now priced to deliver deeply negative real returns over the long term. To be willing to buy the SPX with a negative equity risk premium one would have to either have highly optimistic expectations of future fundamental growth or expect Fed easing to drive up valuations.

Regarding growth, SPX earnings are already at a near record 6.7% of entire gross national income and 38% of global public equity earnings as measured by the FTSE All Cap Index. SPX earnings are also at an unimaginable 40% of total US savings. While a small number of tech companies have been enjoying record profits, the overall economy is suffering from a precipitous decline in savings. Earnings growth will inevitably have to fall unless the overall economy picks up pace, and despite the recent improvement in macro surprises, leading indicators from the yield curve to the Conference Board’s Leading Indicator Index suggest trend growth will continue to slow.

Regarding interest rate cuts, the Fed is highly unlikely to cut rates as aggressively as expected while ever financial conditions remain so lose amid the current market euphoria. Easy financial conditions tend to precede rising inflation expectations and 2-year market implied inflation expectations have risen 60bps since the start of the year. Higher inflation prints will make it difficult for the Fed to ease at all, and there is significant room for rate cut expectations to be unwound.

Even A Small Decline In Stocks Could Trigger An Avalanche

Parabolic market moves have a reliable tendency to result in subsequent busts by nature. The marginal buyer of stocks during such advances tends to take their cues from their own p and l. Human nature means that when stocks are rising confidence increases and buying continues to be justified and rewarded by rising prices in a self-reinforcing manner. The lack of any pullbacks causes investors to abandon their hedges and take on more risk. At the same time, both active and passive investors are also forced to add exposure to the best performing stocks in order to prevent painful underperformance relative to the benchmark.

However, as investors add to winning positions, it only takes a small decline for losses to start piling up and panic to set in, bringing about indiscriminate selling. With the yield on cash so much higher than the yield on stocks, even the failure of markets to continue rising could be enough for investors to abandon stocks as they realise they are better off in cash.