"Can continue to enjoy the AI bull market," but Nomura warns: now is not the time to give up on hedging

Nomura Securities' latest analysis points out that although the foundation of the AI-driven bull market in the U.S. stock market remains solid and investors can still participate, the market has accumulated significant downside risks, and abandoning hedging strategies now would be a dangerous move.

According to strategist Charlie McElligott, the current market is in a state of "AI-induced frenzy," creating a virtuous cycle that drives stock indices to continually set new historical highs. This sustained rise is forcing previously skeptical investors to chase prices higher, further fueling this rally.

However, McElligott warns that while hedging strategies may weigh on short-term performance, investors "must not abandon hedging now." He points out that the market is facing significant "downside convexity" under extreme net long positions, negative gamma, and potential volatility squeeze risks. Once a catalyst occurs, declines could be exponentially amplified due to negative gamma, high leverage, and crowded long positions being forcibly liquidated, creating an accelerating downward curve.

Market dynamics also confirm this contradictory situation. On one hand, the skew in the options market has sharply decreased, with demand for call options significantly increasing relative to put options, indicating strong bullish sentiment. On the other hand, technical indicators show that systemic capital flows are prepared for "asymmetric selling," increasing the market's vulnerability to a pullback.

Behind the AI Frenzy, Multiple Factors Support the Continuation of the Bull Market

Nomura believes that the current bull market in U.S. stocks is supported by multiple factors. First, the Federal Reserve's policy focus has shifted from combating inflation to paying attention to the labor market, and its dovish turn has provided the market with easing expectations. Second, fiscal stimulus and massive deficit spending in the U.S. and globally are still ongoing.

At the same time, the high-income consumer group in the U.S. is affluent, becoming the absolute main force in consumption. The loose financial environment—including a weaker dollar, high values of securities investment portfolios, substantial returns on cash assets, extremely narrow corporate credit spreads, and drastically compressed cross-asset volatility—also provides strong support for the market. Additionally, thanks to the strong performance of U.S. consumers, nominal GDP remains at a healthy level of around 5%, and corporate earnings have shown remarkable resilience.

Among these, the "AI halo" effect represented by large technology stocks has become the core theme driving market risk appetite. The strong cash flow of these companies not only supports robust capital expenditure but also funds unprecedented stock buybacks, becoming the ultimate source of demand in the stock market and supply of volatility

Warning Signals: The Circular Investment Model Raises Concerns

Despite the strong reasons for a bull market, McElligott also pointed out some unsettling phenomena in the market. He mentioned that recent collaboration announcements among tech giants reveal an increasingly dangerous circular "AI revenue/capital expenditure" model. In this model, the giants are investing billions of dollars back and forth among each other for capital restructuring.

This phenomenon somewhat resembles the "Vendor Financing" that emerged in the later stages of the internet bubble. However, McElligott also pointed out the key differences: First, the current capital cycle is primarily driven by cash rather than debt; second, unlike the internet 1.0 companies that lacked clear business models at that time, today's data centers are generating real revenue from actual users. Nevertheless, the emergence of this model should make the market feel a bit uneasy about the current sustained rise.

Market Sentiment Indicators: Investors Are Chasing Upward Trends and Increasing Leverage

The market has ignored these potential risks, instead once again chasing the upward options of U.S. stock indices, presenting a situation of "prices up, volatility up" (Spot Up, Vol Up). Data shows that investors are increasing their holdings in high beta, high volatility, and short-concentrated stocks, while also increasing leverage as stock indices hit historical highs.

The performance of the options market is particularly noteworthy. The SPX index options skew is "plummeting off a cliff," with demand for call options sharply rising relative to put hedging tools, and the call skew has soared to its steepest level since the beginning of the year, indicating that investors are competing to purchase upside protection for "the stock market to continue soaring." Meanwhile, put options (i.e., downside protection) are gradually being discarded as costs consume them amid the market's continuous rise.

Why Hedging Strategies Are Crucial

Nomura's warning centers on the fact that the market's technical structure has become extremely fragile. Currently, the supply from various volatility selling strategies has led market makers to accumulate the largest long gamma exposure near at-the-money options this year, which suppresses short-term market volatility and creates a "slow grinding" upward trend.

However, the danger lies in the fact that systematic capital flows have already "prepared for asymmetric selling under volatility compression." The comprehensive rebalancing and hedging demand in the options and leveraged ETF markets indicate that the potential selling pressure to buying demand ratio is close to 2:1, which poses a significant "de-leveraging liquidity risk."

In summary, McElligott's conclusion is clear: investors can continue to participate in this AI-driven bull market, but given the extreme positioning of the market and potential downside "convexity," maintaining hedges is an indispensable risk management tool at this stage