Stock-market investors expecting smooth 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 slowing inflation fueling speculation that the Federal Reserve is nearing the end of its interest-rate hikes, equity-derivative traders are expecting a break from the turmoil that has raced markets over the past year. That pushed the so-called volatility curve – a plot that shows expectations for the severity of price changes in the coming months – lower at every point than last year.

Other historical data points also suggest that the optimism of the past two weeks was 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 at the start of this century, which lasted three years. Nothing along those lines is expected in 2023, at least in the base-case scenarios from most Wall Street strategists.

“With how bad last year was, there was a lot of bad news that was probably already priced into the markets,” said Ryan Detrick, chief market strategist at Carson Group. He thinks the US will avoid a recession, which would be a “major positive catalyst” for stocks. “We are seeing steps in the right direction of inflation. That is the key to the whole puzzle.”

Of course, investors shouldn’t expect completely smooth sailing from here. Indeed, January after a double-digit annual decline in history was 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 Department of Labor reported that the The consumer price index fell in December from the month before and posted its smallest annual increase since October 2021. The data was widely seen as giving Fed officials room to further downshift the pace of rate hikes at the February meeting.

Stock-market gains are good news for equity bulls after the S&P 500 posted a more than 19% loss in 2022, its worst hit since the financial crisis of 2008. The good news is such low years are usually followed by a rebound: The S&P 500 has rallied 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 reasons to see the glass as half full on inflation and reject the central bank’s hawkish” rhetoric, said Emmanuel Cau, a strategist at Barclays Plc.

However, there are still reasons for lingering concern among stock investors, who pulled $2.6 billion from US equity funds in the week to January 11, according to a Citigroup Inc. note citing EPFR Global data.

It is possible that the Fed will ultimately defy market expectations. For example, officials indicated that traders were wrong to expect an interest rate cut later this year. And the latest round of corporate earnings reports are just beginning to be released and bring their own risks.

Those who doubt January’s gains will be sustained can also point to their own pattern. Of the four times that markets have posted double-digit declines in a year since the turn of this century, stocks fell in the first month of the following year three times.

But for now, traders at least do not expect any major shocks. The two major economic reports of the month – the employment figures and the consumer price index – have been released and show that growth continues to continue and inflation is decreasing.

The Cboe VIX Index — a gauge of expected price changes in the S&P 500 that typically moves in the opposite direction of the index — finished last week at around 18, its lowest since January.

Institutional investors have hedged their short equity bets over the past few weeks and earlier this month boosted their net-long positions to the highest since May 2022, the CFTC’s Ned Davis Research analysis found. data shows.

“If there is a recession where it lasts about two quarters, by the time we get to the second half of the year, the markets should be pricing in a recovery,” said Ed Clissold, chief US strategist at Ned Davis Research. “If there is continued favorable inflation data and if earnings come in well, you can make the case that hedge funds will continue to cover their short positions, which could be good fuel for the continuation of rally.”

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