Investor Angst Emerges in Riskiest Stocks on Rate Uncertainty

(Bloomberg) -- Investors are starting to hedge the risk of a drop in the Russell 2000 Index of smaller companies, despite investors remaining bullish on large-cap stocks.

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It’s a sign the stock market is splitting into two lanes. One is dominated by the large companies benefiting from artificial intelligence trade, while the other is made up of firms more sensitive to oil prices and interest rates.

Small and mid-cap indexes are “the first area we’ve seen a pick up in hedging demand in the past six weeks,” said Mandy Xu, head of derivatives market intelligence at Cboe Global Markets.

A rising demand for protection against losses in small caps looked prescient on Tuesday, when a jump in 30-year Treasury yields to the highest level since 2007 sent the Russell 2000 down 1.6%. The technology-heavy Nasdaq 100 Index fell less than 0.9% and the S&P 500 dropped 0.7%.

Worries that the Federal Reserve will have to raise interest rates before the end of the year is likely driving a pickup in demand for hedges, Xu said. A rise in interest rates will likely hit small caps the hardest. With the Iran war sending oil prices surging, which bleeds into inflation reports, markets are pricing in a roughly three-in-four chance of a hike by December.

“Tighter monetary policy tends to be more of a drag on small-cap stocks,” she said by phone.

The dynamic stands in contrast with the S&P 500 Index, where the relative demand for puts, even after a pickup last week, remains modest, according to Xu. There, optimism is high the largest companies will advance following Nvidia Corp. earnings on May 20.

“It’s hard for the S&P to sell off as long as the AI theme holds up,” Xu added.

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Optimism around all things artificial intelligence has lifted both small- and large-cap stocks to multiple records this year. The S&P 500 has advanced 8.1% since early January, while the Russell 2000 has gained 12%.

That doesn’t mean that things won’t change in the future, as worries about valuations getting stretched and positioning excessive are getting louder. Still, some market watchers are skeptical that owning Russell 2000 puts is a good idea.

“The problem is, if Nvidia blows out earnings and then you have the SpaceX IPO, I can’t imagine a world in which the equity market doesn’t surge into SpaceX,” said Brent Kochuba, founder of options data provider SpotGamma.