Following the Federal Reserve's interest rate cut last month, the U.S. stock market has embarked on a new round of trading. As more and more industries join the rally, the three major stock indices have risen for six consecutive weeks, marking the best performance since last year.
However, many institutions have also spotted hidden dangers in this market frenzy, warning that adjustments may come unexpectedly. Coincidentally, the International Monetary Fund (IMF) warned investors in a report released this week to be vigilant against a recurrence of the turmoil seen in early August.
Market sentiment is overly complacent.
After the Fed's interest rate cut, the optimistic sentiment about a soft economic landing has provided a new impetus for the U.S. stock market. The rise of cyclical sectors and rotation has somewhat reduced the market's dependence on tech giants, with the small-cap Russell 2000 index once touching a near three-year high.
However, many Wall Street market participants have begun to notice that, from many data and indicators, an overly fervent bullish sentiment may imply that the risk of adjustment is brewing. First, the distribution of options' long and short positions, the Dow Jones Market Summary Chicago Board Options Exchange (CBOE) found that the put-call ratio, which measures market sentiment, touched 0.44 in the latter part of last week, the lowest level since July 11, 2023. In the past, when this ratio fell below 0.5, the stock market often experienced a pullback.
Secondly, investors have placed heavy bets on U.S. stock futures. Weekly data from the U.S. Commodity Futures Trading Commission (CFTC) shows that net long positions in S&P 500 mini futures have held over 1 million contracts for four consecutive weeks, representing over $306 billion in capital inflow. Considering that these positions are usually enhanced through leverage, they are more susceptible to impact if the market takes an unexpected turn.
Citi's Global Head of Quantitative Research, Chris Montagu, stated that the net long positions in S&P 500 index futures have reached the highest level since July 2023, and a similar bullish bias was observed before the S&P 500 index subsequently adjusted. "The last time the market positioning was this stretched, the S&P 500 index fell by more than 10% over the next 2-3 months. We are not suggesting that investors should start reducing their risk exposure, but the positioning risk does indeed rise now."
CS McKee's Chief Investment Officer, Brian Allen, pointed out that the market's optimism is evident in many aspects and is somewhat complacent, "Stocks are popular again. There are many people talking about, do you own Nvidia, do you own Netflix? There are signs that people are enthusiastic about investing in the stock market."
Third, valuations have further deviated from historical levels. Currently, the forward price-to-earnings ratio, calculated based on profits for the next year, has exceeded 21 times, reaching the highest level since July 2021. Michael Kramer, Portfolio Manager and Founder of Mott Capital Management, said, "From my perspective, no matter how you slice the market, it looks expensive."
In addition, a slowdown in share buybacks by listed company executives and severely overbought technical indicators are also reasons why many analysts believe caution is warranted.IMF Warns of Repeated Turmoil in August
The IMF stated on the 22nd that even in the face of increasing geopolitical uncertainty, investor sentiment appears to be quite optimistic.
At the beginning of August, the unexpected release of the US employment report, coupled with the Bank of Japan's surprise interest rate hike, triggered concerns about the health of the global economy, causing significant fluctuations in the capital markets. Tobias Adrian, Director of the IMF's Monetary and Capital Markets Department, said: "We have spent a lot of time thinking about this issue. (The severe sell-off in August) was just a flash in the pan, or is it an imperceptible nonlinear canary in the system. We are uneasy about whether there will be a larger sell-off, and whether this sell-off will be more prolonged."
The IMF stated that the growing disconnect between market uncertainty and low volatility means that adverse surprises in inflation or economic growth could lead to a surge in volatility and complicate the task of the Federal Reserve or other central banks in reducing inflation and achieving a soft economic landing.
The report indicated that although the market events in August did not last long, if they were to continue, they might raise concerns about financial stability. This is because when shocks arrive and volatility increases, hedge funds may further unwind leveraged positions, and algorithmic traders may sell in a declining market to protect themselves from further losses. The IMF warned that current market valuations are still high and could adjust suddenly.
Looking ahead, the Federal Reserve no longer provides forward guidance as in the past and relies more heavily on data. The IMF said in the report that if the Federal Reserve clearly states that the path of policy rates should not overreact to any single data point, it could help alleviate market volatility risks. The IMF expects that the Federal Reserve will further gradually lower interest rates, but may not be as optimistic as the market expects. Adrian said that the Federal Reserve does not want to prematurely declare victory over inflation.