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One veteran Wall Street analyst says that ‘Financial speculation is clearly pervading society.’Carlo Allegri/Reuters

Mounting investor nerves over the strength of the U.S. stock market rally has sparked a dash to buy insurance against spikes of turbulence, lifting a popular financial fear gauge to a record high.

The S&P 500 index of blue-chip U.S. equities has climbed more than 16 per cent in 2021, extending its gains since last year’s coronavirus nadir to 92 per cent and solidifying the bull market recovery as one of the strongest on record.

However, given lofty valuations and the shake-ups that can erupt over the thinly traded summer months, some investors are now buying insurance against sharp stock market declines.

As a result, the Skew Index, which measures the difference between the cost of derivatives that protect against big market drops on one side and the right to benefit from a rally on the other, has hit record heights.

The Skew gauge rises when fear outpaces greed, so the widening divergence indicates how worries are bubbling up beneath the stock market’s seemingly placid surface.

“It shows that people aren’t completely switched off,” says Andrew Sheets, managing director, head of cross-asset strategy at Morgan Stanley in the Boston area. “There’s a narrative that markets are complacent, but if you look at the options markets you can see that people are paying up for protection.”

Although the global economy has bounced back strongly since pandemic lockdowns began to be rolled back, investors still worry about issues ranging from central banks scaling back their extraordinarily aggressive stimulus to the spread of the highly infectious Delta strain of COVID-19.

“To make the case that broad equity valuations are attractive, you have to rely on an argument that there’s no practical alternative,” says Rob Sharps, group chief investment officer at T. Rowe Price, in the asset manager’s mid-year outlook. “That would rest on a continuation of low interest rates and low inflation.”

The Skew Index is compiled by the Chicago Board Options Exchange and is constructed to typically range between 100 to 150 points, in which a value of 100 signals that stock market movements are expected to be roughly normal, and higher readings indicate that investors are paying up to hedge themselves against crashes.

The index has mostly drifted upward over the past decade, but has climbed particularly sharply over the past month as rising demand for protection has swamped the fading willingness of other investors to sell it.

That lifted the index to a record 170.5 points last week, according to Refinitiv data. At the end of Wednesday it was at 161.8 points, still elevated compared to its three-decade average of 119 points.

“Markets have priced heightened probability that the current low-volatility environment switches to much higher volatility should markets sell off,” wrote Rocky Fishman, a derivatives analyst at Goldman Sachs Group Inc. in New York, in a note.

Richard Bernstein, a veteran Wall Street analyst, says that the U.S. stock market currently ticked off all the defining characteristics of a bubble.

“The difference between mere speculation and financial bubbles is speculation resides within the financial markets, but bubbles pervade society,” he said in a note. “Today, financial speculation is clearly pervading society.”

However, many investors remain firmly positioned for the equity market bull run to continue. Bank of America’s most recent client survey indicated that fund managers are taking close to the most risk that they have since the poll began in 2001 and are holding cash reserves of just 3.9 per cent on average, near the lows seen over the past decade.

Moreover, the Vix Volatility Index, the Skew’s more famous fellow derivatives-based measure of investor fear, has tumbled to the lowest levels seen since the coronavirus pandemic began to rattle markets in February 2020 due to the sharp decline in actual stock market volatility.

The Skew Index does a poor job of predicting market calamities, and technical factors such as withdrawal of big option sellers in the wake of the March 2020 turmoil may be helping to pull it higher. But analysts still say it is a decent proxy for the strength of fear and greed among investors.

The elevated level of Skew indicates that at least some investors are growing increasingly worried that the long stock market rally is overdue a setback. Moreover, many traders and investors go on holiday over the July and August period, which can exaggerate the market impact of any news.

“Summer liquidity is never great, and people might be just trying to buy some protection before they go on their holidays,” Mr. Sheets says.

During Capital Group’s recent mid-year outlook presentation, the divergence between the economy and markets was deemed “disconcerting” by Pramod Alturi, fixed-income portfolio manager at the asset manager in Los Angeles.

“The economy is in an early cycle. Markets have moved a lot faster,” he says. “There is a lot of risk out there.”

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