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There are many reasons to rule out a year-end rally.

Optimistic expectations for a traditional year-end rally are rare. Faced with levels of inflation that markets haven’t seen in at least 40 years and are still running, many believe the Fed has no choice but to create a recession to combat it. A priori, macroeconomic fundamentals justify their pessimism. But what lessons can we learn from psychological foundations? Namely those from the options markets.

For Julien Messias, head of research and co-founder of Paris-based management firm Quantology, the correlation and interplay of implied volatility show significant potential for a year-end rally. “Since late October, I have observed that the implied correlation of three-month free call options on the Nasdaq 100 index is significantly higher than usual,” he said in an exclusive interview.

“The fear of losing money is a stronger feeling than the hope of gaining it”

The expert, who is also an expert in behavioral finance, reminds that when the market moves strongly, the chances of stocks moving in the same direction increase. That is, the correlation increases significantly. This is especially true when the market is down. Julien Messias continues: “In this scenario, premiums for put options are generally higher than for call options because the fear of losing money is a stronger emotion than the prospect of winning.”

It notes that for calls on indices where strike prices are higher than market prices, i.e., the out-of-the-money (OTM) implicit correlation is generally quite low. “We’re talking about an implied correlation of about 40-45%. On the other hand, it is higher for free bets, i.e. between 65-70% on average. However, what has happened since November is that the implied correlation of OTM calls on the Nasdaq 100 is right around 65-70%.

“These levels generally correspond to the correlation of OTM puts, not calls. We can conclude that the Nasdaq 100 index stock options market expects a significant and rapid rise at the end of the year, during which everything will go in the same direction, in this case, towards growth”, explains the manager. Therefore, instead of a classic uptrend characterized by slow and gradual stock movement as well as large dispersion, the revaluation could be very strong, especially for the technology stocks of the Nasdaq index. A fortiori in the context of the catch-up effect, which can be reinforced by a potential slowdown in the level of inflation risk.

Julien Messias continues: “This is more noticeable because when the market goes up, the correlation is generally less noticeable, even marginal, and the dispersion increases.” (This also points out that stocks go up more often than they go down, but the downs are generally more severe). Furthermore, during 2022, the difference between “value” investments and “growth” investments was particularly significant in favor of the former. “But since the beginning of November, the opposite has been happening,” the Quantology manager insists.

But for Goldman Sachs, JP Morgan or even BlackRock strategists, the markets’ recent prices are inflated. There will be no soft landing from the Fed for the latter. And as a result, they stick to their “overweight” positions in developed market stocks. And on the business side? What do the results of the third quarter tell us?

“Won’t China’s ‘reopening’ issue create at least as much inflation as growth?”

“First, they were quite confident,” said Stéphane Barbier de la Serre, strategist at AIR LAB, also contacted by Allnews. “But, because of the mechanics of the markets, isn’t that always the case?” asks the strategist. Second, in his opinion, the market is no longer infallible in terms of business results. “In other words, companies that disappoint in both revenue and earnings per share are penalized more than ever. This reflects the persistence of bearish sentiment (with volatility to the nearest month) among investors in general,” adds Stéphane Barbier de la Serre. It is emphasized that the main factor that can eliminate uncertainties is that “inflation will remain and remain for a long time.”

From a macroeconomic perspective, even the China factor may not be enough to sustainably restore optimism. “Even if the theme of the Chinese “reopening” remains uncertain, will it not create inflation at least as much as extraordinary growth?”, Challenges Stéphane Barbier de la Serre. “However, Beijing may prefer a policy of small steps. In other words, the effect of this factor will be only gradual.”

Finally, according to the strategist, the rally in international stocks over the past few weeks owes more to the massive retrenchment of short-selling positions by hedge funds than to any real positive change in macroeconomic fundamentals. “This rebound may not be complete in the still very specific context of year-end adjustments. But I can’t see any sector offering a really convincing entry point after last week’s Homeric short squeeze,” concludes Stéphane Barbier de la Serre.

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