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.

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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.”

Another troubling sign is earnings, a key crutch upon which market bulls rested their “this time it’s different, the market will never sell-off thesis.” Corporate profits are starting to turn just as higher than average price earnings ratios need them most – especially in a rising interest rate environment.

BofA’s August Fund Manager survey noted the top tail risks could be a Fed/ECB policy mistake as they start to normalize interest rates and a bond market crash – somewhat correlated events.

BAML Equity Derivatives Research Team Use synthetics to hedge, so long as their correlations hold up during crisis

With similarities to the 2001 and 2008 global financial crisis swirling – and the fact recessions typically operate in near eight year cycles – what is an investor to do?

With stock and bond portfolios recording record high returns relative to Sharpe ratio as both upside and downside deviation are mutating, BofA advises their clients to get synthetic.

“Interestingly, equities have already been adjusting to the increased probability of a tail event by bidding up the price of OTM equity put options, or equivalently, by steepening the S&P 500 put skew and leaving it the most stressed GFSI components,” BofA’s equity derivatives research team wrote, pointing to a relative value opportunity. “While buying outright OTM puts is expensive, an equity/rate hybrid can cheapen the price of hedging tail risk.”

They likewise think historically low implied equity and interest rate volatility amid heightened correlations “make for an attractive entry point for equity/rate hybrids that can cheaply hedge a bond-led equity shock into year-end.” As an example of one such tail hedge, they point to an “S&P 500 6 month 97.5% put contingent on US 10Y CMS > 2.35% can be bought for 1.15%, providing a 60% discount to a vanilla put.”

When the stock market apocalypse comes, they recommend getting synthetic. Just hope that the anticipated correlations that drive hedge performance hold up during a crisis.

 

equity derivatives research team