Are We Heading for a Crash or a Soar? Stock Market Extremes Are Being Prepared for by Traders

Investors, having reaped profits from one of the most robust first quarters for the S&P 500 Index in decades, are now bracing themselves for what lies ahead - whether that entails further stock market gains or a potential downturn.

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As the second quarter commences with the stock market soaring to unprecedented heights, insight into traders' sentiments can be gleaned from the options market. Notably, demand for put options, which pay off in the event of a minor market correction, is currently at its lowest in years. Conversely, traders are discreetly acquiring tail-risk hedges - instruments that offer little protection in mild downturns but safeguard against significant market volatility.

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Overall, it appears that Wall Street is not overly concerned about a minor setback. However, there is a growing apprehension regarding unanticipated risks that could destabilize the bull market.

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"Inflation continues to trend downward, and the Federal Reserve has signaled its willingness to reduce interest rates this year," resulting in a conducive environment for stocks with a notable 10% gain for the S&P 500 in the first quarter - its most robust performance since 2019. Additionally, the index achieved 22 new all-time highs in the first three months of 2024.

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Despite the market's gains being concentrated in a few key stocks, investors are increasingly seeking value in overlooked market segments. Small-cap stocks show signs of a potential rebound, and the tech-heavy Nasdaq 100 Index lagged behind the broader S&P 500 in the first quarter, a deviation from the trend observed last year. Moreover, around 70% or more of S&P 500 firms maintained positions above their 200-day moving averages in each session, indicating an improved breadth not seen since 2021.

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Lisa Shalett, CIO at Morgan Stanley Wealth Management, noted, "The market is showing more confidence in a genuine soft landing or even no landing scenario where overall economic growth in the US continues to stay solid." Consequently, a broader array of companies, including those in cyclical sectors like industrials, materials, and energy, are expected to perform well.

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The resurgence of meme mania also contributed to market dynamics, as retail investors poured into stocks and equity derivatives, capitalizing on events like the Reddit Inc. IPO and the rally in Trump Media & Technology Group Corp. Citadel Securities' institutional options desk data indicates that retail investors are exhibiting their longest stretch of bullish options market positioning since the 2021 meme stock frenzy.

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Despite the prevailing confidence, investors are shedding defenses against minor corrections, as evidenced by the increase in the cost of S&P 500 bullish call options compared to equivalent bearish puts. However, concerns about a significant market disruption persist, reflected in the uptick in positioning for a volatility spike, particularly evident in the Cboe Volatility Index (VIX).

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The timing and magnitude of interest rate cuts by the Federal Reserve remain a chief risk factor. While Chair Jerome Powell reiterated the central bank's cautious approach to policy easing, discussions of sustained higher rates could influence market sentiment in the upcoming quarter.

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Furthermore, the dependence on artificial intelligence darlings to drive index performance poses a potential risk. Barclays strategists cautioned that stretched positioning and technical indicators could prompt a selloff, primarily led by tech shares.

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Nevertheless, these concerns are currently contained, and expectations of another strong earnings season may further drive valuations to elevated levels. This sentiment shift is reflected in the preference for rally-chasing over protective puts among options traders.

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In summary, while there is a degree of complacency regarding minor corrections, apprehensions about unforeseen risks persist, underscoring the nuanced balance between market optimism and cautious preparedness.

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