Like a slot machine paying off on every pull, the stock market’s most reliable bets lately have often been its riskiest.
Go long on a company that sounds like something Elon Musk mentioned in a tweet (but wasn’t)? Signal Advance Inc. just soared 12-fold. Lend money to a software-maker to buy Bitcoin? A Microstrategy Inc. convertible bond is up 50% in four weeks (its option is in the money). Back up the truck on bullish options after the Nasdaq 100 doubled in 24 months? Wednesday was the fourth-busiest day ever for call trading in the U.S. (the other three were last year).
Throw a dart, hit a winner, so it has lately seemed. Emboldened by Federal Reserve stimulus, vaccines and the psychological conditioning that arises when no bad patch lasts, everyone from retail newbies to institutional managers is rushing to cash in on the 10-month-old melt-up. Of course, it’s possible that all of this could continue for weeks, if not months, without so much as even a little reversal. Predicting exactly when such fevers will break is a near impossible task. But bubble warnings are starting to blare from every corner.
“It’s a full-blown mania, and the bull’s relative youth doesn’t make it ‘safer’ to climb aboard,” Doug Ramsey, Leuthold Group’s chief investment officer, wrote in a Friday report to clients — which went on to note his firm has also been among the buyers. “We’re just as guilty as the others in chasing this momentum”
Chasing it is working. Four days after ending the year at almost 40 times earnings, the Nasdaq 100 Index posted its biggest rally in two months. Hedging against stocks, on the other hand, has been costly. A basket of favored manager short positions went against them by 10% last week, rallying the most in seven months. Hoping the mania all goes away is also proving futile. The frenzy over special purpose acquisition companies continued, with a fresh dozen making initial public offering filings Friday, including one with the ticker “LMAO.”
“Too much froth, too much complacency,” said Matt Maley, the chief market strategist at Miller Tabak + Co., who thought last week’s spectacle in Washington would have at least slowed the frenzy. “After a 16% rally in just two months and a 70% rally since March, that news should have knocked down the market. A 10% to 15% correction would be normal and healthy.”
Tesla Inc.’s ability to add 25% to a market value of almost $700 billion over five days made headlines last week, but for real froth, the options market was the place to look. Calls expiring Friday this week with a strike price of $1,000, the most-traded Tesla option Friday, quintupled Friday, ending the week at $9.15 after starting at 53 cents each.
Individuals appear to be driving the action, according to JPMorgan Chase & Co., which cited a proxy for New York Stock Exchange margin-account data indicating a potentially strong pickup in December versus previous months. Small-trader call option buying has snapped back violently after a seasonal dip in the last week in December, as has retail-oriented off-exchange trading, the bank says.
“The liquidity force appears to be reverberating once again in an intense manner via retail investors, in a repeat of the second quarter of last year,” strategists led by Nikolaos Panigirtzoglou wrote in a note Friday. “Given the anticipation of further fiscal support, this force is likely to be sustained over the coming weeks.”
The industry has taken notice. Cboe Global Markets Inc. has been tailoring products to smaller investors. It refreshed mini S&P Index options to enhance liquidity and provide better execution for retail customers, after saying in June it would revive a mini-VIX product aimed at least partially at smaller traders.
The firm tried to “make some products that account for these changes in investor demand, which we believe is here to stay,” Arianne Criqui, Cboe’s head of derivatives and global client services, said in an interview in November. She noted that Robinhood Markets Inc. says only about one-fifth of its customers trade options. “We see great upside” for more people to start, she said.
Sundial Capital Research’s Jason Goepfert has been raising flags since the end of December over how big a force retail traders exert in the options market. He cited data on number of call purchases, and the money spent on them — where the smallest participants had a 54% share versus 28% for the largest.
“By the looks of things, it’s gotten even worse,” Goepfert wrote in a note Tuesday. “The most reliable sentiment measures tend to be those that focus on real money and leveraged instruments. That’s when emotion has the greatest impact. When we look at some of the most leveraged vehicles available to investors, there is widespread evidence of extreme speculation.”
The market is primed for a rush into riskier holdings, given many assets such as cash and bonds are offering historically depressed yields. Some investors have turned to stocks — and options — to generate the income that’s missing with almost everything else. Chris Murphy, a derivatives strategist at Susquehanna, noted in November that overwriting “can be a great way to enhance yields” given the combination of elevated volatility and high valuations.
Andy Nybo of Burton-Taylor International Consulting LLC also sees the hunt for yield contributing to the options frenzy.
“With bond yields at zero rates or very low rates, there’s a whole host of investors looking for yield enhancement,” he said in an October interview. “Options are a powerful tool not only for getting exposure but also a tool for earning yield for existing holders. So overwriting strategies, call writing strategies are all helpful tools for investors to earn yield as well as manage their risk exposure either on the upside or the downside.”
Saying there’s froth at the fringes is not the same thing as saying everything is doomed. In a note last week, strategists at Bank of America tried to plot all the signals pointing to a bear market in broader measures of stocks, and found 63% of them have been met. Among them are dwindling cash in fund holdings, an elevation in the Cboe Volatility Index and buoyant consumer sentiment. While the reading hit a three-month high, it’s short of the peak level of 79% seen in September 2018.
“Our checklist bear market signposts (signals typically triggered before an S&P 500 market peak) grew incrementally bearish,” strategists led by Savita Subramanian wrote. “Our 2021 forecast calls for muted S&P 500 returns.”
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