Investors are hedging for less downside in the stock market, a bullish signal that builds the case for 8% upside in the S&P 500, JPMorgan says

• Less hedging by investors is a sign that there is more upside ahead for the stock market, according to JPMorgan.
• The bank said with signs that inflation volatility is peaking, the S&P 500 should trade at a fair value of 4,400.
• "Reduced demand for hedging equity risk is a bullish signal as it likely reflects low equity positioning by investors," JPMorgan said.

The stock market could be staring at a potential rally ahead as data from JPMorgan suggests that investors' equity positioning remains low.

In a Wednesday note, JPMorgan analyst Nikolaos Panigirtzoglou said that demand for hedging potential downside in the stock market is low. That, combined with signs that inflation volatility is peaking, means the S&P 500 has a fair value of 4,400, according to Panigirtzoglou. That represents potential upside of 8% from current levels.

"Reduced demand for hedging equity risk is a bullish signal as it likely reflects low equity positioning by investors," Panigirtzoglou said. Specifically, the put-to-call ratio of the S&P 500 has remained subdued in recent weeks even as the stock market trended lower, according to the note.

Similar instances when the put-to-call ratio was this low include the end of 2016, the end of 2018, and March 2020, all of which suggests investors are underweight stocks in their portfolios. Those same investors could fuel buying pressure if a swift rise in the stock market materializes, as technical analyst Katie Stockton outlined on Thursday.

But much of that potential upside likely hinges on Friday's key inflation report, which will reveal to investors whether rising prices for goods and services have peaked yet. If they haven't, JPMorgan's fair value estimate in the S&P 500 will likely take more time to be reached.

Economists surveyed by Bloomberg expect the CPI to have been unchanged at 8.3% in May, and expect core inflation to have fallen to 5.9% from 6.2% in April.

JPMorgan thinks even if volatility in inflation remains heightened, investors will look through it, similarly to how investors have looked through the volatility seen in GDP readings. First-quarter GDP showed a contraction for the US economy.

"In all, markets appear to largely continue to look through the spike in inflation volatility," Panigirtzoglou said. But if persistent inflation does continue to surprise investors, there could be significant downside for stocks ahead.

"In the adverse scenario... our longer-term fair value framework suggests a fair value of 3,350. We stress, however, that this is an adverse scenario that would likely require a continuation of inflation surprises," the note said.

A decline in the S&P 500 to 3,350 represents potential downside of 18% from current levels. The S&P 500 traded just below 4,090 in Thursday afternoon trades.