Does Wall Street Believe in Its Own Rally?

Earlier today, the Dow hit 11,000 for the first time since September 2008, up 68% from 13 months earlier. That appears to indicate that Wall Street is pretty comfortable asserting that the U.S. is in the midst of a strong economic recovery. Yet, a report from Bloomberg today might suggest otherwise: investors are increasingly hedging their bets. Do stock traders believe in their own optimism -- or do they smell a bubble?

Bloomberg reports:

The biggest rally in seven decades has left investors so skittish that even forecasts for a 30 percent surge in U.S. earnings are failing to keep them from hedging bets on equities.

The premium on options that insure against losses in the Standard & Poor's 500 Index over those wagering on gains, known as skew, rose to the highest level since June 2008, data compiled by Bloomberg show. Traders sought protection as shares rallied for six weeks, pushing a measure of momentum that compares stocks with their 50-day average to the most bearish reading in 13 months, according to Bespoke Investment Group LLC.

This news is a little troubling. If the market was in broad, unquestioning agreement on the strength of the U.S. recovery, then such hedging wouldn't be as prevalent. Instead, investors are protecting themselves from a market reversal. They may not have faith in their optimistic forecasts.

This hedging behavior could indicate that traders worry stocks are getting a little carried away. After all, a 68% return in a little more than a year is quite a rally. It could be that investors know they are enjoying the upside of an unsustainable bubble. If that's the case, then they would want to continue to participate in the gains, but have some protection for when the market falls back to earth.

Yet, this data doesn't necessarily indicate cynicism -- it could just be smart investing. As mentioned, the market has increased a lot over the past year or so. Even if investors believe in the U.S. economy's ability to sustain these gains, it's prudent to take some action just in case they're wrong. After all, if they really believed a market correction was looming, they would be shorting the market -- not merely hedging their long bets. But if this trend continues, then it could indicate more and more stock traders are becoming skeptical that the rally can endure.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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