In an environment where equity and credit markets just won’t quit, Bank of America Merrill Lynch’s crystal ball has some good news and some bad news for investors. We’ll be kind and start with the good news.
Those two markets are likely bound for a summer of gains — verging on “irrational exuberance” — with all of the conditions aligning for a melt-up, the investment bank’s researchers predict. For one, measures of value at risk are low, suggesting that a build-up of short positions may get squeezed out of the market, perpetuating gains. In a note circulated Thursday, researchers led by Michael Hartnett write:
“According to [Bank of America Merrill Lynch] Hedge Fund Monitor speculators have recently sold SPX to a net short position; Russell 2000 shorts are the highest they have been in 2-years, while Nasdaq longs are at a 1-year low.”
The S&P 500 index SPX +0.54% is up 3.6% so far this year, while the Nasdaq Composite COMP +0.54% has gained 1.4%. The Russell 200 index RUT +0.30% is down 2.1%. The Barclays U.S. credit index, tracked by the iShares Credit Bond ETF CFT 0.00%, has gained 5.7% year to date.
Other conditions are likely friendly for investors looking to continue piling into these markets:
“Cash is high: Our May Fund Manager Survey revealed 5% cash levels, a 2-year high, and well above the normal 3.5-4.5% range.“Volatility is dead: This week the VIX VIX -0.94% index closed at 11.36, its second lowest close since February 2007.“Liquidity is high: as politicians struggle with structurally high unemployment and low income growth, the pressure stays on central banks to reflate, with the unintended consequence of ‘one way’ market trends.”
So the Federal Reserve will keep its key rate projections benign, and the European Central Bank may even take easing measures next week. That will cushion markets from the volatility associated with improving economic data, which may otherwise lead to market fears about policy normalization. In such an environment, assets in emerging markets and struggling European nations are likely to continue performing. Strong cyclical stocks and U.S. tech stocks are also a good bet, the strategists say.
But nothing lasts forever, including this summer of market love. Sooner or later a turning point will be hit, the Merrill researchers say:
“At some point the capitulation into Treasurys will be completed and thereafter bond volatility (and thus equity volatility) will become increasingly vulnerable to events that question the assumption of [zero interest-rate policy] to infinity. We stick with the view that a summer melt-up would likely be followed by a nasty correction in the autumn. But short-term capitulation into asset markets remains a likely scenario.”
Other strategists sounded a similar note of caution on the horizon, but no immediate cause for alarm. Here’s Sam Stovall, equity strategist at S&P Capital IQ, in a Wednesday note about the stock market:
“As this bull market marches higher, one can’t help but wonder if the abnormally low VIX is reminiscent of an excessively low tide that typically precedes a tsunami. In all, while uncertainties caution against excessive exposure, we will let the trend remain our friend.”
But don’t forget that just as many investors take all of these signals as a warning that we’re on a verge of a major market move. John Nyaradi of MarketWatch’s Trading Deck rounds up this take
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