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With U.S. equity markets up 92 percent from their depths of March 2020 and a growing number of analysts warning of a correction, more investors are buying derivatives that would turn a profit if markets fall.
As a result, the Skew Index – the spread between the cost of those derivatives and the opportunity to profit from a market rally – has set a record.
The index rises “when fear outpaces greed,” as the Financial Times put it, meaning that the yawning spread points to swelling anxiety among the markets’ players.
The index, maintained by the Chicago exchange CBOE, normally ranges from 100 to 150 and has averaged 119 since 1990. Readings of 100 indicate that investors see the markets as behaving normally; a rising rating indicates investor jitters.
The index has slowly climbed since 2010, the FT reported, but has ballooned in the last month, notching a record 170.5 during the last week of June.
“Markets have priced probability that the current…environment switches to much higher volatility should markets sell off,” Rocky Fishman, a Goldman Sachs derivatives analyst, wrote in a research note cited by the FT.
“The difference between mere speculation and financial bubbles is that speculation resides within financial markets, but bubbles pervade society,” Richard Bernstein, principal of Richard Bernstein Advisors, wrote in a recent note.
“Today, speculation is clearly pervading society,” he noted. The home-buying frenzy is perhaps the most obvious example.
Investment fund managers now hold one of the highest risk positions since 2001, according to a Bank of America survey, and are keeping just 3.9 percent of their financial arsenals in cash.
TREND FORECAST: Because equity markets detached themselves from economic reality since the end of March 2020, we continue to forecast that markets will keep edging up as long as the Fed keeps the monetary methadone flowing.
Once the Fed clearly indicates when interest rates will rise and its bond-buying will slow, the markets will turn down. How quickly and severely the downturn is will depend on how far in advance the Fed signals its policy changes and the degree and timeline of those changes.