'Pain Trade' on Wall Street Looks Set to Continue

For professional money managers on Wall Street, the current rally in stocks has become a “pain trade,” particularly after an incredibly strong two-year bull run. The term refers to a situation where market movements leave many portfolio managers scrambling to catch up. As stocks continue to climb, buy-side investors are now facing pressure to match benchmarks like the S&P 500, which has risen nearly 23% in 2024, according to FactSet data as of Tuesday morning.

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Charlie McElligott, a strategist at Nomura, explained that hedge funds, systematic traders, commodity trading advisors (CTAs), and other sophisticated investors have been heavily focused on guarding against a selloff. This focus has led many of them to miss out on the possibility of a continued rally, or what McElligott refers to as a “right tail” event. Instead of preparing for a further surge, they’ve been fixated on protecting their portfolios from downside risk.

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Several indicators highlight this cautious sentiment. The Cboe Volatility Index (VIX), known as Wall Street’s “fear gauge,” remains elevated, along with other measures of demand for protective hedges, such as the skew on options tied to the SPDR S&P 500 ETF. These metrics reflect the nervousness among portfolio managers, likely stemming from their firms’ risk management teams. Given the potential risks that could arise and the short-lived shocks that stocks have experienced in recent months, such caution is understandable.

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However, this defensive stance has weighed on the performance of many funds, even as historical data suggests that stocks tend to perform well when implied volatility—captured by the VIX—is at its current levels or higher. Despite the S&P 500 setting its 46th record close of the year on Monday, the VIX remains elevated at around 20, slightly above its long-term average. This combination of record highs and heightened volatility suggests that many on Wall Street are still concerned about potential risks, particularly with the U.S. presidential election approaching.

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Over the past three months, macro funds and long-short hedge funds have underperformed compared to the S&P 500, trailing the index by 7.3 and 2.2 percentage points, respectively, according to Nomura’s data. This level of underperformance is significant when viewed in a historical context. If stocks continue to rise, these firms and others will likely be forced to chase the rally. McElligott highlighted an example of a large order for out-of-the-money calls, specifically for SPY calls with a $615 strike price, which hit Nomura’s trading desk shortly before he shared his latest commentary.

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Goldman Sachs analysts have also noted this shift in buy-side firms’ hedging activity. In a recent note, they pointed out that portfolio managers are showing increased demand for upside calls, a trend that mirrors McElligott’s observations. Goldman Sachs even coined a new acronym to describe this behavior: “FOMU,” which stands for “fear of materially underperforming” an equity-market benchmark. This fear is driving firms to chase the rally as they try to avoid lagging behind the market.

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There are several reasons why this chase may intensify. Corporate stock buybacks are expected to accelerate as U.S. companies exit their buyback blackout period later this month, providing additional support for stock prices. Stock buyback programs have surged in popularity throughout 2024, and this trend is likely to continue. Additionally, households typically increase their stock purchases after a presidential election, further fueling the rally.

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Once the election is over, implied volatility is expected to decline, which could encourage systematic funds and multi-manager hedge funds to leverage their equity positions heading into the end of the year. Historically, November and December have been strong months for stock market returns. Meanwhile, the end of the fiscal year for mutual funds should reduce tax-related selling pressure on some of the year’s underperforming stocks, according to the Goldman Sachs team.

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As old hedges expire worthless and traders open new bullish positions, options dealers will be forced to hedge their exposure by buying S&P 500 futures. This could push the market even higher. Eventually, systematic funds, CTAs, and even long-short discretionary managers will be compelled to increase their exposure to stocks, adding more momentum to the rally.

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While U.S. stocks were mixed on Tuesday, both the S&P 500 and Dow Jones Industrial Average appeared set to pull back slightly from their record highs reached on Monday. Meanwhile, the Nasdaq Composite saw gains, with stocks like Apple and Alphabet helping to offset a pullback in Nvidia, which had hit its first record high in four months on Monday.

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In sum, professional money managers are facing a challenging environment as they balance the need to protect against potential risks while also keeping up with a surging market. The fear of missing out on gains is prompting many to reconsider their cautious stance, and as the rally continues, more funds may be forced to join the chase, fueling further stock market momentum.

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