BANK OF AMERICA: There's glaring evidence that 2 market bubbles are fast approaching their destruction. Here's how exactly they will burst.
"Twin bubbles" in financial markets are poised to peak in the second quarter, according to Michael Hartnett, the chief investment strategist of Bank of America. He explains the factors that could end these displays of "irrational exuberance," and shares his investing strategy for right now. Click here for more BI Prime stories.
The Federal Reserve has played an outsized role in simultaneously securing the longest equity bull market and economic expansion in history. At every juncture since the Great Recession, the Fed has intervened with a lifeline. Most recently, it pumped billions of dollars into short-term lending markets last September when a cash crunch set in, and continues to provide liquidity. But there are unintended outcomes of these stimulative measures, according to Michael Hartnett, the chief investment strategist of Bank of America. In a note Friday, he pinpointed two broad areas where "excess liquidity" is brewing bubbles. And he provided multiple examples of their manifestations. The first bubble is in scarce yield assets. Sovereign bonds take the cake in this category. Bank of America data shows a record $481 billion flowed into bond funds in 2019 even as the value of negative-yielding debt soared to a record exceeding $16 trillion. This misnomer — investors chasing assets with sub-zero yields — was so prevalent last year that another strategist concluded he was seeing "the greatest bubble ever." While Hartnett does not size the trend as such, it is clearly a bubble in his book. The second bubble he flagged is in scarce growth assets. For this one, Hartnett was armed with multiple examples of investments that have caught on like wildfire because of their prospective returns. Unsurprisingly, Tesla was his first example of present-day "irrational exuberance." Bulls like the company because it is a trailblazer in the electric-vehicle industry. But the past few weeks have been head-scratching: shares soared 141% and then fell 29% within just 25 trading days on no groundbreaking news. Many market watchers cited a combo of short sellers being squeezed out of their bearish bets and a contagious fear of missing out. Besides the Tesla phenomenon, Hartnett cited the boom of exchange-traded funds as another example of irrational behavior. Despite all the cost and diversification benefits of ETFs, he noted that a whopping 2,712 of them have been created over the past two years. Yet another sign of growth excess that Hartnett cites is the private equity industry's bid to offload $1.5 trillion in unspent capital by lurching into shadow banking. According to PitchBook, the five-largest PE closes in 2019 were for buyout funds. How the bubbles burst Given the trends outlined above, the big question is when and how it all ends. Hartnett pins the timing of a "big top" to the second quarter, at which point he says he will turn "rationally bearish." As for the triggers, one that already gives Hartnett cause for concern is that the S&P 500 is soaring to all-time highs even though new capital goods orders, a forward-looking gauge of business sentiment, remains flat. A more distant catalyst is a reversal of the Fed stimulus that has helped markets stay afloat. Hartnett envisions a scenario where investors' optimism about the election fuels animal spirits and prompts the Fed to scale back its liquidity support. An additional trigger Hartnett envisions is that investors completely underprice the biggest risks they have placed on the back burner for now, namely an economic recession, inflation, and credit defaults. Until these scenarios play out, Hartnett is staying "irrationally bullish" on risk assets during the first quarter. He sees the S&P 500 rising to 3,498 — a 5% rally from current levels that would mark the stock market's longest and largest bull market in history. But once these records are in the books, all bets are off. SEE ALSO: Famed economist David Rosenberg explains why he puts the odds of a recession at 80%. He says the Fed is squarely to blame. Join the conversation about this story » NOW WATCH: A big-money investor in juggernauts like Facebook and Netflix breaks down the '3rd wave' firms that are leading the next round of tech disruption
More like this (3)
JPMorgan provides 5 charts that suggest the stock market still has 'plenty of room' to rise from current levels
Stocks still have plenty of room to rise from current levels, according to a note published...Stocks still have plenty of room to rise from current levels, according to a note published by JPMorgan on Friday. The bank largely pointed to investors' underweight equity positioning as a main driver for stocks to move higher over the medium to longer term, despite near-term risks of elevated momentum. Investors' allocation to stocks is 40%, which is below historical averages and is well below the early 2018 high of 49%. With bonds yielding next to nothing, investors may return to stocks and drive up prices as fears over the coronavirus pandemic subside. Here are the five charts JPMorgan pointed to in support of its bullish view on stocks. Visit Business Insider's homepage for more stories. Stocks still have "plenty of room" to rise further from current levels after a nearly 40% rally off the lows, according to a note published by JPMorgan on Friday. The bank acknowledged that short-term risks are present, especially with elevated momentum positioning by traders, which signals overbought levels. But over the medium to longer term, JPMorgan said it thinks stocks are the place to be. The short-term overbought condition is "not enough by itself to stop or derail a bull market underpinned by four medium to longer term drivers," the bank said. Those four drivers include a still-low overall equity positioning backdrop; a rapid healing of funding markets; a structural change in the liquidity and interest rate environment; and a rapid economic recovery driven by steady lockdown relaxation. Part of JPMorgan's argument is similar to a recent note from Bank of America, which pointed to a potential "Great Rotation" by investors from bonds into stocks. Despite the nearly 40% rally in stocks since the March 23 low, investors' stock allocation "isn't much different from last March's backdrop as the rise in cash holdings and the expansion of the value of the bond universe partly offset the equity rally," the bank said. Read more: David Herro was the world's best international stock picker for a decade straight. He breaks down 8 stocks he bet on after the coronavirus decimated markets — and 3 he sold. JPMorgan said it thinks investors will increase their allocation to stocks given the favorable backdrop of high liquidity and low interest rates. Here are the five charts JPMorgan used to expand on its reasoning for being bullish on stocks.1. Short interest remains elevated This chart is a short interest proxy of the S&P 500 index. It shows that bearish traders still have elevated short bets on the market. As the market grinds higher, the bank expects shorts to cut their losses and close out their short positions, which would creating buying pressure in stocks. 2. Investors are underweight stocks Non-bank investors currently have a 40% allocation to equities, which is below its historical average and below its 2018 high of 49%. The chart shows that there is plenty of room to move higher for investors' allocations to stocks. JPMorgan believes equilty allocations are likely to increase over the next few years thanks to low interest rates and high liquidity. Investor fear surrounding the coronavirus pandemic would likely help improve equity positioning as well. 3.Investors are overweight bonds On the flip side of investors' low equity positioning, is their current allocation to bonds. Investors rushed into bonds amid the coronavirus pandemic, pushing the bond allocation to 24%, well above its historical average of 19%. As investor fear over the virus subsides, and investors wake up to the near-zero interest rates they're receiving with their fixed income holdings, it is very possible that they will rotate into stocks, according to JPMorgan. 4. Cash positions remain elevated JPMorgan's implied cash allocation level has also spiked amid the cornavirus pandemic, but remains at its historical average of 37%. The bank said given cash yields are zero across the board for the foreseeable future, "it remains reasonable to expect this cash allocation to decline further over the medium to longer term." With more than $4 trillion in cash on the sidelines, JPMorgan isn't the only one looking for that cash to be put to use into stocks. 5. Funding markets are healing Most important to the economy is the ability for credit markets to function properly. If a company is cut off from raising new debt in the credit markets, it could be put in a poor position that ultimately ends in bankruptcy. Fed Chair Jerome Powell's main mission with the Fed's monetary stimulus policies, such as buying high-yield debt, was to make sure the credit markets could still function, and companies could still raise much-needed money amid an economic crisis. It looks like Powell's actions helped calm the credit markets. Besides back-to-back record debt issuance by corporations in March and April, JPMorgan pointed to the spread in Libor interest rates stabilizing at levels around 30 basis points as evidence that the credit markets are functioning properly.
Bank of America warns a new bubble may be forming in the stock market — and shares a cheap strategy for protection that is 'significantly' more profitable than during the last 10 years
The attractiveness of US assets relative to the rest of the world is brewing a bubble...The attractiveness of US assets relative to the rest of the world is brewing a bubble in the stock market, according to equity-derivatives strategists at Bank of America. They formulated a cheap strategy designed to profit from limited gains in some of the worst-performing stocks. Click here for more BI Prime stories. Stock-market rallies do not have to be as monumental as the dot-com boom in order to qualify as bubbles. For equity-derivatives strategists at Bank of America, the forces lifting the market higher are powerful enough to potentially make stocks vastly overpriced. None of these catalysts is hard to dismiss — even for bearish investors who doubt that the economy will quickly recover from the coronavirus crisis in a V-shaped manner. Most importantly, the US has provided more monetary and fiscal support than any other country during this downturn and made the appeal of its financial assets irresistible. The concern shared by Bank of America is these gains could prompt investors to dust off a playbook that worked after the 2008 financial crisis: buying price dips and betting that weaknesses will be short-lived. Quant investors who are insensitive to price and willing to add more risk to their portfolios then join the buying, creating a marketwide fear of missing out that fuels the market higher. "A major risk therefore is the formation of a US equity bubble as fundamentals take a backseat to investors' need to allocate capital to what's arguably the safest risk asset left," said a team of strategists including Gonzalo Asis in a recent note. The backdrop for this bubble scenario is the worst economic contraction since the Great Depression, which investors appear to be tossing to the back seat. But the strategists' study of every contraction since 1929 led to the conclusion that a a sustained rebound from the March low would be a historical anomaly. And so, we're left with two competing risks. Investors who are skeptical that this time is different may need to capitulate and buy a market that just keeps flying higher. And on the other hand, stocks may simply be staging a classic bear-market rally that collapses. Bank of America's recommendation is not to pick one of these sides. Instead, the strategists devised a strategy that would help investors hedge the bubble risk while participating in its upside. They view it as a cheap way to "rent" rather than own stocks that might rise. The team's apparatus involves call spreads, designed to bet on limited price gains. It is executed by simultaneously buying and selling an equal number of call options. The strategists screened for stocks in industries with the worst performance since the market peaked in February 19, as these have more upside room. Also, the chosen stocks have a historically flat call skew, meaning traders are not paying a premium to bet on price increases. "Call spreads on Delta, Wells Fargo, United Airlines, MGM Resorts, and Aflac offer significantly higher payout ratios than typical over the past 10 years," Asis said. SEE ALSO: Bill Miller and 5 longtime value investors share 10 stock picks they're betting on right now — and explain why these are the best companies for the crisis recovery Join the conversation about this story » NOW WATCH: Why Pikes Peak is the most dangerous racetrack in America
UBS lays out market strategies for all 3 economic-reopening scenarios, from a successful recovery to a COVID-19 resurgence
Uncertainty around the coronavirus pandemic's trajectory has led Mark Haefele — chief investment officer at UBS...Uncertainty around the coronavirus pandemic's trajectory has led Mark Haefele — chief investment officer at UBS — to detail three strategies for various economic-reopening scenarios. The bank's more optimistic scenario sees the US avoiding a second wave of COVID-19 cases and reopening through June. Value and cyclical stocks would be best positioned for a faster-than-expected rebound, the CIO said. Haefele's baseline forecast pushes a return to normal economic activity into December. Investors would do well to sink cash in bonds and long-term themes like sustainability, he wrote. If an economic recovery falters, investors should turn to active management strategies, gold, and even Treasury Inflation-Protected Securities to ride out a lengthy recession, Haefele added. Visit the Business Insider homepage for more stories. UBS chief investment officer Mark Haefele is covering all the bases. He penned a letter to clients on Thursday laying out three market strategies for various economic trajectories. Haefele said the US sits at a key fork in the road, with lingering coronavirus risks, renewed US-China tensions, and high valuations threatening to drag markets back to March lows. On the other hand, positive news out of coronavirus vaccine trials has lifted investor sentiments in recent weeks. Uncertainty around the pandemic's containment is the key variable to lifting markets from their now-narrowed range, Haefele said. "For markets to catch a 'second wind,' investors need greater confidence that a 'second wave' of virus infections will not lead to renewed lockdowns," he wrote. "Even if current economic conditions are weak, markets are forward-looking and would likely trade higher if investors gain confidence that a robust recovery will take hold." The best near-term strategies depend on how economic reopening takes place. Outlined below are the three scenarios and market plays highlighted by Haefele, from a swift summer upswing to a rush for defensive assets. Read more: The world's biggest investors are notoriously skeptical of the stock market's bet for a quick economic recovery — and warning that the 'fantasy' rally will soon come crashing downUPSIDE SCENARIO: Buy cyclicals and value UBS's upside scenario sees the economy coming back online through May and June without the need for a second lockdown. Corners of the market that underperformed through the worst of the pandemic would present serious value and outperform on the upswing, Haefele said. Both cyclical and value stocks would be best positioned for a better-than-expected recovery. US mid-cap firms haven't shifted to "stay-at-home" trends as quickly as their larger peers, leaving them better prepared to gain on a return to past norms. The relaxing of mobility restrictions will particularly help automakers, beverage, and retail companies, the CIO wrote. Read more: John Fedro quit his job and got involved in real estate with barely any money. He breaks down his low-cost approach to mobile-home investing, which allows him to live comfortably on passive income. For those eyeing a shift to value stocks, the battered energy sector is the place to be. A rebound in oil demand stands to lift the entire segment, and US energy stocks already reflect crude prices "significantly below our longer-term normalized price expectations," Haefele said. Investors should watch out for a weaker dollar should the economy soar back to past levels of growth. While the currency appreciated through the crisis, a slide in liquidity demand will drive the dollar's value lower. The British pound is the best currency for a foreign exchange trade against the dollar in such a scenario, UBS said. Read more: 'Likely to be excruciating': A notorious stock bear says investor reliance on Fed money-printing is misguided — and warns of more than 50% crash from current levels BASE CASE SCENARIO: Favor credit and long-termers Haefele's baseline scenario projects economic reopening taking place through the summer and economic activity returning to past highs in December. The more moderate recovery puts credit bets in a healthy spot relative to equities, the CIO wrote. Investment-grade debt, emerging-market bonds, and high-yield credit are all well-positioned for gains thanks to widespread government relief, he added. "Policymakers have done enough through their fiscal and monetary response to ensure liquidity issues do not become solvency issues for companies or sovereigns that were viable prior to the crisis," Haefele said, adding that the Fed's direct purchase of corporate bonds further lifts the asset class. Even if the recovery isn't as quick as desired, UBS's base case creates long term opportunity in the healthcare, e-commerce, automation, and cybersecurity sectors. Sustainable investing will likely gain new appeal as well, with investors paying greater attention to green and socially responsible firms, according to the bank. Read more: 'It works for anything I look at': BlackRock's bond chief who oversees $2.3 trillion shares the 'really simple' 3-part framework that guides every investment decision he makes — and outlines 2 factors he looks for in a company DOWNSIDE SCENARIO: Buy gold, pick stocks selectively Haefele doesn't offer as clear a picture of what his pessimistic scenario would look like, instead hinting at fresh credit-health shocks and sharp volatility tearing into markets. In the case of a prolonged recession, one safer bet for investors would be to follow historically successful hedge funds. Active stock picking could help "navigate periods of elevated volatility" better than passive stock-and-bond positioning, the CIO said. A cocktail of surging US debt, tightened financial conditions, growing geopolitical risks, and dollar devaluation would do wonders for the price of gold, UBS added. The precious metal has already enjoyed a rally to eight-year highs, and even in the bank's base case, it expects gold to gain another 4% to $1,800 per ounce by the end of the year. A more severe downturn would only further boost the popular safe haven. Lastly, Haefele suggests investors turn to Treasury Inflation-Protected Securities, or TIPS, to offset the chances of soaring inflation. The trillions of dollars spent on economic aid led the market to price in record-low inflation for the near future, so any shift could benefit those holding the protected bonds. TIPS will also gain value if central banks adopt higher inflation targets moving forward, the CIO said. Now read more markets coverage from Markets Insider and Business Insider: Hedge funds are piling into healthcare stocks at record levels, Goldman Sachs says Banks may not be profitable until 2025 even as major economies recover, new IMF report says These 11 stocks loved by hedge funds have beaten the market during both the coronavirus collapse and its subsequent recovery, RBC says