(Bloomberg) -- The US stock market’s fundamental flows are turning increasingly bullish, which should give equities a fresh jolt once the US election is out of the way.
The elements of a rally are building up — stocks are entering a historically strong season and companies are starting to buy back shares. Investors may be over-hedged for the series of earnings, US election and central bank risks looming through early November. And with market volatility declining from the early-August high, systematic investors and options desks may be forced to snap up stocks.
Selling by mutual funds — typically the biggest offloader of stocks — is fading into the end of the month. That’s set to reverse, with November typically seeing inflows into equities, while at the same time the corporate buyback window is re-opening with an estimate of $6 billion of buying every single day in November, according to Scott Rubner, a managing director for global markets and tactical specialist at Goldman Sachs.
As the US presidential race comes down to the wire, stocks are holding near record highs in an environment dominated by risk management concerns, with traders made wary by volatility shocks in the past two months and the upcoming string of risk events.
The increase in hedging can be seen in elevated premiums for S&P 500 puts versus calls, and also in weekly Commodity Futures Trading Commission positioning data. As of Oct. 22, non-commercials — including hedge funds and other speculators — were net-long Cboe Volatility Index futures for the first time since 2018, according to the CFTC.
The market remains over-hedged, said Nomura’s cross-asset derivatives strategist Charlie McElligott, adding that there is going to be a unwind of the hedges if risks clear, creating a “mechanical bid” into the year end. “Many are already under-capturing the equities move which is already escaping them as we rally into election” and they will be looking to chase the rise on fear of missing out, McElligott wrote to clients on Monday.
McElligott noted that over the past week he has seen some investor flows starting to position for a rally. Unwinding hedges and increased bullish buying could then lead to a so-called “vanna tailwind” — where a drop in options volatility approaching the next big quarterly expiry in December may leave dealers having to buy back more contracts to cover short index futures positions.
The vanna effect may play a similar role in propelling the market post-elections as it did in 2020, says Garrett DeSimone, head of quantitative research at OptionMetrics. “The idea is that volatility has been priced higher due to hedging against election risk. Once this risk is resolved and the worst fears do not materialize, volatility is typically crushed,” he says.
Simultaneously, lower options implied volatility and a drop in realized volatility levels as the big spikes from August and September move further into the past will prompt volatility-control funds to rebuild exposure by also buying into the future market, with estimates from Nomura going as high as $145 billion of buying over the next three months should the market stay relatively calm.
With 30-day implied volatility still trading about 6 points above realized volatility, the market remains in a state of pricing uncertainty rather than experiencing true stress.
The potential rally is likely to be amplified by lower liquidity in the upcoming holiday season, with few willing sellers around to meet a strong burst of buying coming from many sides.
“Our default view remains that election & FOMC passing lead to a contraction in implied volatility, which lifts equity markets,” note the strategists at Tier 1 Alpha. “That being said, it does seem that next week likely serves as a key turning point, with little to spark moves until at best Friday.”
(Updates with volatility data in third-last paragraph.)
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