Dazed and exhausted stock buyers can finally catch their breath

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(Bloomberg) — Stock market investors hoping for a breather after a brutally volatile 2022 have history — and options traders — on their side.

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With a slowdown in inflation supporting speculation that the Federal Reserve is nearing the end of its rate hikes, equity derivatives traders are expecting the turmoil that swept through markets last year to end. That has caused the so-called volatility curve — a graph that shows expectations for the severity of price swings in the coming months — to be lower at every point than it was a year ago.

Other historical data also suggest that the optimism of the past two weeks is not misplaced. Among them: since 1950, during the recession of the early 1970s and after the burst of the dot-com bubble at the turn of the century, which lasted three years, there have been only two consecutive annual stock market falls. Nothing of the sort is expected in 2023, at least not according to the base case scenarios of most Wall Street strategists.

“With how bad last year was, there is so much bad news that is probably already priced into the markets,” said Ryan Detrick, chief market strategist at Carson Group. He thinks the US can avoid a recession, which would be a “major positive catalyst” for equities. “We see steps in the right direction with inflation. That is the key to the whole puzzle.”

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Of course, investors shouldn’t expect things to go smoothly from here. In fact, after an annual double-digit slump, January has historically been a rough month for the S&P 500 index.

Still, the S&P 500 was up 2.7% last week and is up more than 4% this year. On Thursday, the Labor Department reported that the consumer price index fell in December from the previous month, recording the smallest annual increase since October 2021. The data was widely believed to have given Fed officials room to adjust the pace of rate hikes in February.

Those stock market gains are welcome news for stock bulls after the S&P 500 posted a loss of more than 19% in 2022, its worst blow since the 2008 financial crisis. The good news is that bad years like these are usually followed by a recovery: the S&P 500 has recovered by an average of 15% over the next 12 months, according to data since 1950 compiled by Carson Group.

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“Markets may have good reasons to view inflation as a glass half full and dismiss hawkish rhetoric,” said Emmanuel Cau, a strategist at Barclays Plc.

Yet there are still grounds for continued fear among equity investors, who withdrew $2.6 billion from U.S. equity funds in the week through Jan. 11, according to a note from Citigroup Inc. citing EPFR Global data.

It is possible that the Fed will ultimately defy market expectations. For example, officials indicate that traders are wrong to anticipate interest rate cuts later this year. And the latest round of corporate earnings reports is just beginning to be released and comes with its own set of risks.

Those skeptical gains from January that will be sustained may also point to their own precedent. In the four times that markets fell by double digits in a year since the turn of the century, stocks fell three times in the first month of the following year.

But for now, at least, traders don’t expect any major shocks. This month’s two main economic reports – the employment data and the consumer price index – have already been published and showed that growth is holding up and inflation is declining.

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The Cboe VIX index — a measure of expected price movements in the S&P 500 that normally moves in the opposite direction of the index — ended last week at around 18, its lowest level since last January.

Institutional investors have covered their short positions on equities in recent weeks and earlier this month increased their net long position to the highest level since May 2022, Ned Davis Research’s analysis of CFTC data shows.

“If there is a recession that lasts for about two quarters, markets should be pricing in a recovery by the time we get to the second half of the year,” said Ed Clissold, chief US strategist at Ned Davis Research. “If favorable inflation rates continue and earnings are pretty good, you could argue that hedge funds continue to cover their short positions, which would be pretty good fuel to continue the rally.”

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