With Fall Tail Risk All Around, BofA Says Get Synthetic With Hedges

This fall could be an eventful one, even when compared to a relatively eventful August. Everything from the US Federal Reserve starting to gradually withdraw quantitative stimulus from the veins of the markets to a US debt ceiling showdown and various moves from major developed market central banks around the world to bank analysts saying the global market cycle is over could face investors come fall. But don’t worry, say the equity derivatives research team at Bank of America Merrill Lynch. The answer is to hedge with synthetics.

The market is showing signs of Tulip mania

Analysts at HSBC Holdings Plc, Citigroup and Morgan Stanley think investors are ignoring obvious signs of risk and they will pay the price come fall.

Their logic is that long-standing correlations between stocks, bonds and commodities that were established based on deep economic links have broken down at a time when investors are ignoring valuation fundamentals and even core economic data.

BofA magnifies these concerns. In an August 22 Global Equity Volatility Insights publication, analyst William Chan and the equity derivatives research team think valuations are rich, with the S&P 500 forward price earnings ratio hitting its loftiest level since the Tech Bubble of 2001. Even bonds don’t look save, with a risk premium 50% above its long-term average. With markets generally ignoring earnings and standard valuation metrics this Tulip mania could crash soon.

“This is clearly a concern for portfolios that invest in both classes,” they wrote, pointing to a correlation breakdown that led to the 2013 “Taper Tantrum” market crash and the August 2015 stock market crash. And they aren’t alone.

“Equities have become less correlated with FX, FX has become less correlated with rates, and everything has become less sensitive to oil,” Andrew Sheets, Morgan Stanley’s chief cross-asset strategist, told clients Tuesday. “These low macro and micro correlations confirm the idea that we’re in a late-cycle environment, and it’s no accident that the last time we saw readings this low was 2005-07.”