Concerns about a U.S. stock market bubble intensify as traders "buy insurance" to cool down the AI market ahead of tech giants' earnings reports

According to Zhitong Finance APP, for investors in the U.S. stock market, they can easily find signs that the market seems to be in a bubble— the S&P 500 index has rebounded 36% since its low in April, with valuations rising to levels comparable to previous "overly exuberant" periods.

For most of the past two months, the relative calm in the derivatives market has been a strong rebuttal to such concerns. The Chicago Board Options Exchange Volatility Index (VIX) has remained well below its long-term average. Meanwhile, the correlation of individual stock volatility has dropped to its lowest level since February this year, which is seen as a healthy sign by most market observers.

However, this argument has recently been challenged. Just as individual stock correlation remains low, the VIX index has begun to rise slowly. A VIX index breaking above 17 is viewed by derivatives traders as a signal that institutional investors are worried that any misstep in AI trading, which has driven the market up this year, could trigger an overall market correction.

Steve Sosnick, Chief Strategist at Interactive Brokers, stated, "One thing I’m watching is that when the VIX is no longer falling, even as the correlation between individual stocks continues to decline, this divergence period is often worth noting. There is a stronger sense of tension in the market, and people are hesitant when buying stocks. Don’t fight the market trend, but be prepared for surprises."

On Wednesday, as the S&P 500 index rebounded from a sharp drop and the VIX index fell back below 17 almost without any news, "buy-the-dip" buyers reappeared. Tech stocks continued to lead the way—consistent with the trend this year. This is the main reason for the low correlation among individual stocks— the impact of AI trading is too pronounced.

Strong gains in AI beneficiaries like Oracle (ORCL.US) and AMD (AMD.US) have driven the U.S. stock market higher, while consumer stocks and companies viewed as "losers" in AI, such as Salesforce (CRM.US), have seen their stock prices decline, leading to a still low market breadth. This year, nearly all of the S&P 500 index's gains have been concentrated in about 10 AI giants.

With just a few weeks to go before major tech companies like Apple (AAPL.US), Alphabet (GOOGL.US), and Microsoft (MSFT.US) report their earnings, derivatives traders are increasing protective positions in case any of these companies underperform.

Tom Essaye and Tyler Richey from Sevens Report Research wrote in a report sent to clients on Tuesday, "If any of these companies disappoint, the market will lack broader fundamental support to sustain the current rally." They specifically mentioned AI-driven stocks. These two analysts believe that even a slight cooling of enthusiasm for AI could trigger a roughly 5% correction in the S&P 500 index Investors have various ways to increase protective positions. One common approach is to use put options on the Invesco QQQ Trust ETF as a hedge against declines in the Nasdaq 100 Index that the fund tracks.

Steve Sosnick stated, "The smarter place to buy insurance is the Nasdaq 100 Index rather than the S&P 500 Index, because the correlation between the two is high, but the Nasdaq 100 typically has stronger volatility." Due to the more intense fluctuations in the Nasdaq, the option prices for technology stock indices are usually slightly more expensive.

For investors who are unwilling to operate derivatives themselves, there are now hundreds of exchange-traded funds (ETFs) in the market that can execute the same strategy. For example, the JPMorgan Nasdaq Equity Premium Income ETF not only holds large technology stocks but also includes downside protection against significant market declines. More aggressive traders may focus on VIX index ETFs, such as the 2x long VIX futures ETF. These funds can surge several times within days during market sell-offs but then quickly retreat, making long-term holding very costly.

Steve Sosnick also mentioned that setting aside funds to cover hedging costs may be a wise move, "The more you lean towards AI stocks in April, the worse your performance will be."