There's still a chance of a 'fat right tail' for stocks, these strategists say

By Steve Goldstein

Over the past 25 years, third-quarter earnings season has been the most volatile

After the Federal Reserve's historic half-point interest-rate reduction, what do investors now have to look forward to?

Quite a bit, it seems. BNP Paribas's equity derivatives team produced a roadmap for the next two months, which includes the possibility of a "fat right tail."

A right tail is a reference to a chart where the negative values are on the left side and the positive values are on the right.

This chart shows what the bank views as the best possibility for the stock market - a red wave giving Republicans control of the House, Senate and White House, along with a soft landing for the U.S. economy. The worst in their view would be the combination of a blue wave giving the Democrats control of all three, along with a hard landing.

Strategists led by Greg Boutle, head of U.S. equity and derivatives strategy at BNP Paribas, said that the red wave is the more likely scenario, given the likelihood of Republicans controlling the Senate. "In a soft-landing scenario with a reacceleration in macro data and a bullish election outcome, we could see a very large point-to-point rally but on low realized volatility. This is exactly what happened in 2016," they said.

The Russell 2000 Index RUT rallied for 15 consecutive sessions around the election, they noted, and the gains in the stock market strongly exceeded what the options market had priced in.

The market won't just be shaped by politics and data, however. They pointed out that, over the last 25 years, the third-quarter earnings season has been the most volatile, and produced the best returns, measured by one-month gains after the start of an earnings season. "This seasonality could be attributed in part to the importance of Q3 guidance setting expectations into year-end for the subsequent year's earnings," they said.

Another point was that positioning is still defensive even with the stock market perched near record highs. The S&P 500 SPX entered Thursday only 0.9% away from a record high and quickly exceeded that level on an intraday basis.

That's seen in the sector split - utilities XLU being the best sector this year - as well as their models of trend-following and volatility-targeting funds, which are in neutral territory. "In our view, this won't mitigate a large spot drawdown if the data warrants it. However, it might affect the path and make a drawdown less violent or volatile than it otherwise would be," they said.

A year-end S&P 500 straddle is worth around 375 points, which they say is attractive given the wide 500-point trading range the S&P 500 has seen recently. "Given the wall of catalysts into year-end, we view optionality as attractive to own," they concluded.

-Steve Goldstein

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09-19-24 1522ET

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