While it has been a sleepy summer and, in general, a sleepy 2023, we think that the back half of 2023 is going to be very different that the first half. Our proprietary indicator tells us that volatility is about to make its way back into markets. It is a signal we have developed, taking cues from some of the best and brightest traders and researchers. It only gives us these clues every couple of years. Right now, it is flashing caution. It tells us that volatility is about to rise in the market, and there is a way to play that trade. As a rise in volatility is usually accompanied by a fall in stocks, it also implies that stocks are about to fall, but that is not guaranteed. Our data indicates that we would expect this to start to come to fruition over the next couple of weeks and that stocks should fall between 5-20%.
We mentioned several weeks ago in our letter that it would be most like the market to suck back in all those who had sought shelter for the coming recession. We also mentioned that a break above 4200 on the S&P 500 would be the cause. The rise to 4600 has pulled everyone back into the water. Systematic strategies are back and “all in,” while hedge funds net leverage is approaching the 99th percentile. Going back to 2008, downside protection in puts has never been cheaper. One of the best trades in 2023 has been selling volatility. That is like picking up pennies in front of a steam roller. We think the steam roller is about to have its day.
We see the coming uptick in volatility as an opportunity. This is not the crash of 2008 or 2020.
Band of America writes that we are seeing a turn in psychology, but this is not complacency, according to the investment bank. Such sentiment uplift, especially after a long stint in the panic zone, often suggests a shift in investor psychology rather than complacency, similar to trends observed during 1990-91, 1998-99, 2001-02, 2008-09, 2011, and 2015-16.
We will know if the shift in sentiment turns this into the beginning of a more prolonged bull market when the S&P 500 tests the 4000-4200 area. A short-term selloff of 9-13% would present itself as a healthy selloff burning off positioning too heavily weighted towards the bulls.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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