BofA: “It’s All Starting To Get A Little Stretched”

First you have Goldman warning that a 20% crash in the market  would lead to some rather unpleasant side-effects for the broader economy (why warn now?) and now Bank of America – which just two days ago threw all caution to the wind when it raised its S&P year end price target from 2,800 to 3,000 – “went there” admitting what everyone knows, i.e., “It’s all starting to get a little stretched.”

So why did Bank of America just hit peak schizophrenia and turn both more bullish and more cautious at the same time when the MSCI All World index is up more than 5%, while the Dow, Nasdaq and HSI are all up more than 6%, 7% and 10% respectively?

The answer is simple. On one hand, the bank has to chase price, and do what its sellside peers are doing, which is raising S&P price targets simply because the S&P is in melt up mode and won’t stop until there is a crash. BofA also makes the case that fundamentals are still supportive of prices, and “the strong data means we are positive on the prospect for earnings, with global growth looking to come in at 4%, or still better, if the surveys are to be believed. That keeps our quant models bullish, with the Global Wave up for the 20th month in a row. Against such a backdrop earnings growth is likely to better consensus again in 2018.

On the other hand, however, not even Bank of America can ignore to the underlying reality of a market which now screams not only record overvalued on virtually every metric…

… but also the most overbought ever. As a reminder, we already showed earlier this week that on a weekly basis, the S&P’s RSI has never been higher.

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There’s more, and as BofA strategist James Barty writes, while “we know markets don’t usually go up in a straight line… equity markets have completely ripped since the start of the year, so much so that Michael Hartnett has calculated that the S&P 500 would top 6,000 by year end if we carried on like this (we re-calculated and as of now it’s >7k!). The period without a 5% pullback is now at an all time high and the weekly RSI on the S&P 500 is at a post war high.”

It doesn’t stop at the S&P, however, as other equity markets are following suit with the RSI on the HSI at 88! At the same time bond yields have broken higher with the 10Y Treasury through 2017 highs. Meanwhile, the trends in Oil, Cyclicals and Defensives all look stretched, according to BofA.

All these “rubber bands” are shown in the charts below which confirm that the market may be prone to a violent snapback.

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Then there are flows: in last week’s Flow Show we saw a massive $23.9bn one week flow into equities, while the 4 week flow was the biggest ever at $58bn. 4 week flows into active equity funds rose to a 4 year high.

“So what should traders do”, Bank of America asks rhetorically, musing whether there could be a melt up, like 1999/2000. Here is its answer:

Well anything is possible and FOMO (or the fear of missing out) can be a powerful driver. Nevertheless, our job is to look at markets in probabilistic terms.

  • Can we carry on at 6%+ per month? No.
  • Are markets overbought? Yes.
  • Are our  models telling us it is getting a bit frothy? Yes.
  • Are we finally meeting clients who are more bullish than us? Yes.
  • In addition we have now broken the record for the longest period of time without a 5% correction in the S&P500.

Sooner or later we will have one of those corrections and the more markets melt up the more likely it is.

So in light of abundant red flags everywhere, what should investors do? The Bank’s advice: “dial down risk

The conclusion is that you should be dialling down risk. There are, of course, two ways to do that – take off trades or add hedges. Given that our timing is rarely perfect and in bull markets overbought conditions can wear off through consolidation we are more inclined to add hedges at this point. It’s not impossible that the melt up continues in the short term if we don’t get a catalyst to prompt de-risking. In addition short dated volatility is very low by historical standards, which means that protection is not particularly expensive. We still think outright long vol positions are less interesting as they would be unlikely to pay off if it is only a correction and not something more serious.

So what about a longer-term outlook? Here it all depends on central banks and inflation. Here again is BofA:

The bull run in equities is likely to continue, we think, until inflation starts to pick up triggering a more aggressive response from central banks. Markets have got a bit more twitchy about such an outcome since the start of the year with the BoJ’s reduction in long bond purchases, more hawkish ECB minutes and strong US data pushing rate expectations higher.

Finally, is there a risk of an emergency unannounced rate hike?

Of course, if the market continued to melt up then central banks might be tempted to hit the brakes without a pick-up in inflation in order to dampen down asset price inflation. We think that would require the current run to continue for a while yet as central banks would want to be a lot more convinced that it was getting out of hand before risking such a move without price inflation picking up first.

In other words, 4 years after Yellen first warned about frothy valuations, at a time when stocks are both record overvalued and overbought, central banks are still ” not convinced” that things are getting out of hand? We eagerly look forward to Bank of America’s safe advice to let us know just when that moment will finally take place.

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