In the stock market, not everything is as it seems.
Slowing inflation has boosted investor confidence in the economy this year, which, combined with enthusiasm for artificial intelligence, has helped drive stock prices higher than expected.
The S&P 500 rose 15 percent in the first half of 2024.
The gains have been surprisingly steady, with the index only rising or falling more than 2% in a single day once. (It rose.) Widely tracked indexes that expect more swings to come are nearing record lows.
But looking beneath the surface reveals a much bigger mess: Nvidia, for example, whose stock price surged last week to become the most valuable public company in the U.S., is up more than 150% so far this year. Additionally, its stock price has experienced multiple sharp declines over the past six months, wiping billions of dollars from its market capitalization each time.
More than 200 companies, or about 40% of the stocks in the index, are at least 10% below their highs this year. About 300 companies, or about 60% of the index, are more than 10% above their lows this year. And each group contains 65 companies that have actually swung in both directions.
Traders say the lack of correlation between individual stocks, known as diversification, is historically extreme and undermines the notion that markets are calm.
One such measure, an index from exchange operator CBOE Global Markets, shows that variance has increased since the coronavirus pandemic as tech stocks surged while others fell. Analysts say variance has remained high, thanks in part to the extraordinary gains of some stocks on the cutting edge of artificial intelligence.
That's an opportunity for Wall Street, as investment funds and trading desks rush to diversify — a strategy that typically uses derivatives to bet that volatility in individual stocks will remain high while index volatility will remain low.
“It's everywhere,” said Steven Crew, a partner at Fulcrum Asset Management and a longtime diversified trader. He believes the trends outweigh even the most anticipated economic data in terms of their importance to financial markets. “GDP and inflation data are pretty much irrelevant at this point,” he added.
The risk for investors is that stocks could start moving in unison again, perhaps triggering a broader sell-off, leading some to worry that the complex volatility trade could reverse roles and exacerbate rather than soothe turbulent conditions.
Decentralized trading.
Estimating the total value of these types of transactions is difficult, even for people who are deeply involved in the market, in part because there are multiple ways in which these bets can be made. Even in its most basic form, a decentralized exchange can involve several different financial instruments being bought and sold for a variety of other reasons.
How big is it? “That's the million-dollar question,” Crews said.
But there are some clues: The options market is expanding rapidly, with more than 12 billion contracts expected to trade this year, up from 7.5 billion in 2020, according to the CBOE. And while there have always been specialists with nifty strategies for trading derivatives, mainstream fund managers are now reportedly getting involved.
Assets in mutual funds and exchange-traded funds that trade options, including diversified ones, have swelled to more than $80 billion this year, from about $20 billion at the end of 2019, according to Morningstar Direct. And bankers, who offer clients a way to replicate sophisticated trades without the technical expertise, say they are seeing growing interest in diversified trading.
But the influx, the magnitude of which is not fully known, is drawing comparisons to the last time volatility trading was popular in the years leading up to 2018.
At the time, investors flocked to options and leveraged exchange-traded funds, which boasted big returns during market downturns but were vulnerable to sudden sell-offs that increased volatility. These trades were clearly “short volatility,” making money when volatility was down but suffering big losses when markets rose sharply.
So when the markets suddenly crashed in February 2018, with the S&P 500 dropping 4.1% in a single day, some of the money disappeared.
While this trend continues, analysts say it is far less significant and the emergence of popular diversification strategies is fundamentally different.
Because this trade seeks to profit from the difference between low index volatility and high volatility of individual stocks, even in the event of sudden selling pressure, the outcome is usually more balanced, with one more likely to rise in value while the other falls in value.
However, this generalization also depends on how the trades are executed, and there are still situations where investors can get into trouble. This potential outcome is one of the reasons why decentralized trading is currently getting so much attention: it's possible that everything will work out, but it's very difficult to know for sure, and what happens if it doesn't?
“The firewood is very dry,” said Matt Smith, a fund manager at London-based asset manager Raffer, “and there's a lot going on in the world and the weather is hot.”
The breakup can be ugly.
Importantly, the market's biggest players are also diversified. Microsoft, a beneficiary of the AI craze, is up 20 percent this year. Tesla is down 20 percent. Nvidia has posted astounding gains and remains the outlier.
So even on a day like Monday, when Nvidia fell 6.7%, the S&P 500 only lost 0.3%, as the index was buoyed by other stocks, especially tech giants like Microsoft and Alphabet.
Calmness appears to be prevailing despite a sharp drop in one of the index's major components.
The results could be painful if megacap stocks all start to fall at the same time, as they did in 2022. Diversifying trades could make things even worse.
Even if S&P 500 volatility spikes due to a selloff in stocks like Nvidia, if the damage is limited to specific tech or AI-related sectors, asymmetric outcomes could hurt many diversified trades, industry experts say. Traders looking to limit losses could make trades that exacerbate the volatility, amplifying losses.
That possibility is hypothetical: Nvidia has yet to meet demand for its chips and profits continue to soar. Given these unusual market trends, bankers and traders said the volatility could continue for a while.
But for some professional investors familiar with the intricacies of diversifying trades, the push to ever more extreme levels of trading has made it less appealing.
Naren Karanam, one of the market’s biggest diversified traders at hedge fund Millennium Partners, has scaled back his trading as he sees fewer opportunities to make profits, people with knowledge of his decision said.Rival hedge fund Citadel lost its head of diversified trading in January but opted not to choose a replacement.
Some investors who remain in the market say they have little appetite to increase trading in the current extreme conditions of very low volatility at the index level and very high dispersion among individual stocks. Meanwhile, others are starting to take contrarian positions, bracing for a crash.
“The variance can't get any higher, and the volatility can't get any lower,” said Henry Schwartz, global head of client engagement at Cboe. “There's a limit.”