BofA-ML sees 'contrarian' signal to buy shares, despite risk of bond bubble bursting
A widely-followed market timing indicator flipped into a 'buy' signal on Thursday, pointing to better than even odds, albeit not by much, of a near-term rally in stocks, although bonds were most likely set for a correction.
Bank of America-Merrill Lynch's Bull&Bear gauge declined from a reading of 2.4 to 1.3 over the past week, driven by outflows from emerging market debt and stocks, a jump in demand for Treasuries and 'oversold' conditions in MSCI equity country indices, triggering a so-called 'contrarian' signal to buy risk assets.
And now, in September, the direction for markets likely to inflict the maximum amount 'pain' was up, on the back of a "temporary peak" in trade war fears and because the month was expected to see monetary easing, the investment bank's strategists said.
One of their preferred trades for the month were shares of banks from the European Union, with BofA-ML noting how Wall Street was a 70-year high relative to Europe just as Brexit was set to kick-start fiscal stimulus in the bloc.
America's S&P 500 meanwhile was expected to lag the equity rally.
Yet BofA-ML also highlighted the risk that the bond bubble might burst and result in a disorderly rise in market interest rates.
Hence, they added: "Any short-term sell-off in silver, gold & volatility should be viewed as entry point to hedge against the bond bubble risk."
On the flip-side, an orderly rise in yields might materialise given the historically very low allocation of S&P 500 companies' corporate pension plans to equities, the elevated number of firms offering dividend yields more than 300 basis points above government bond yields and the "absurd" level of rates, what with European investment grade bond yields at 0.24%.
The last time that Bull&Bear indicator signalled a buy - and quite accurately - was on 3 January 2019.
Since 2000, the median return for global stocks in the three months following each of the 16 different 'buy' signals had been 6.3%, while the yield on the benchmark 10-year US Treasury note had climbed by 50 basis points.
That is to say, on half of those occasions stocks had returned more than 6.3% and during the remainder less that that.
Put another way, in the case of shares, the 'hit-ratio' was 10 out of 16, although for the rise in yields it had yet to fail, having proven correct in all of the 16 past such episodes.
Nevertheless, for 2019, BofA-ML retained a 'bullish' view on risk assets, due to the combination of 'bearish' positioning by investors but 'bullish' monetary policy.
Thus farm, the US-China trade war had resulted in lower interest rates, not a recession.
However, looking out 2020, BofA-ML was 'bearish' due to a mix of economic recession, policy impotence and the risks of a bubble in bonds which would induce a "Big Top" in credit markets, leading to a trough in credit risk spreads and in equities as valuation multiples hit a peak.
In terms of the upside and downside risks to their outlook for financial markets, the strategists said: "+ve risk is orderly rise in yields and Great Rotation from bonds to stocks as policy makers successfully postpone recession; -ve risk is bond bubble bursts causing disorderly rise in yields, Wall St deleveraging & Main St recession."