ASSET ALLOCATOR SPOTLIGHT

Fueled by an in-line CPI print on December 12^th and a market perceived Fed “pivot” at the December 13^th FOMC meeting, an end of year “everything rally” ensued with a notable exuberance for US small cap equities. The options market in particular has seen aggressive buying of IWM (iShares Russell 2000 ETF) call options. The volume of IWM call options traded hit all-time highs this month as investors piled in, speculating on further upside in US small cap equities. Most notably, on December 14^th, 1.833 million calls were traded, the most IWM call options ever traded in a single day. The 5-year chart of IWM ETF price (red) is plotted vs. the IWM total call volume below, showcasing how drastic the increase in call volumes has been towards the end of this year.

Source: Bloomberg

Moreover, there is relatively very little interest in downside protection as evidenced by the put/call skew for S&P 500 options. Put/call skew compares how the implied volatility (and therefore expensiveness) of put options compares to the implied volatility of call options. In general, there is almost always a larger demand for put options compared to calls and that demand drives the implied volatility higher for puts than it does calls.

Below is the SPX (S&P 500 Index) 3-month 25delta skew charted over the previous 5 years, defined as the price difference between SPX 3-month 25delta put versus SPX 3-month 25delta call. For example, when this index peaked in March 2020 investors were paying $28.81 more per contract for puts versus the equivalent 25 delta call. That put/call skew bottomed at just $3.41 on Dec. 14^th which is the lowest the demand for S&P 500 puts vs. calls has been in over 5 years.

Source: Bloomberg

The speculative fervor in the market is very sentiment driven at present. There has been very broad participation in the rally, which contrasts with the heavy buying of the Magnificent 7 (AAPL, MSFT, GOOG, AMZN, NVDA, META, TSLA) during much of the year. Based on an American Association of Individual Investors (AAII) sentiment survey, sentiment is also on the higher end of the range, with 32% of survey respondents more bullish than bearish.¹ These survey responses contrast to the -26% result in late October before the rally.

Signs point to a moderation of the recent rally or perhaps even a pullback in Q1, 2024, as this level of market exuberance is likely not sustainable over the medium to long term.

¹ AAII Investor Sentiment Survey | AAII

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