Another day, another piece of ‘bad news.’ No matter. Be it tariff troubles, geopolitical tumult, or worries about the state of U.S. institutions, the Nasdaq Composite and S&P 500 will make another all-time high by day end. Maybe the Dow or Russell will even come along with.
Despite macroeconomic jitters and mixed economic data, investors remain extremely bullish on the U.S. markets. As a result, money managers and institutions are betting that the rally will continue, citing strong earnings and fundamentals.
Investment giants like UBS have raised their price targets for the widely-watched S&P 500 index, while Bank of America’s monthly fund survey has found that fund managers reducing their nearly record-low holdings of cash.
In the latest indication of the lengths to which investors will call themselves bullish, some hedge fund investors are now shorting volatility. In other words, betting that the market will not be unpredictable or chaos.
But if the past is any indication, that’s cause for caution among investors.
What are hedge funds doing?
The VIX, sometimes called Wall Street’s ‘fear gauge’, has settled in to year-lows after a turbulent April, all while U.S. markets marched higher. On Tuesday, it sat at 15.01.
Its months-long descent from April highs has been met by opportunistic hedge funds, who are betting that there’s nothing to fear anymore. Leaning into the northward lurch of U.S. equities, they’re betting against the VIX.
Per Bloomberg’s Jess Menton, net shorts on the Cboe Volatility Index VIX reached levels not seen since Sept. 2022, citing data from the Commodity Futures Trading Commission.
But there are plenty of reasons to suspect that these institutions are wrong.
For one, Menton observes that such moves generally precede increased levels of volatility and losses. In other words, when investors bet against volatility, they usually end up blindsided.
Second, April’s market downturn has demonstrated that investors have a tendency to underestimate political outcomes, especially from the Trump Administration. In fact, many on Wall Street were lackadaisical about the Trump administration’s promises on trade and immigration. Their reaction to his tariff policy demonstrates just how naive; they sent the VIX exploding to over 50.
Third, investors might be moved by earnings, but they are equally moved by ‘Fedspeak.’ Expectations of interest rate cuts in September, and in subsequent months, are currently elevated. However, this decision pends economic data which is increasingly unreliable. And further, investors remain ambivalent about the President’s incursions into the business of the independent Federal Reserve.
So if record markets, record valuations, and record low cash holdings weren’t warnings enough about irrational exuberance, these bets against volatility might just be the cherry on top. Investors might be wise to tread lightly.
