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- Equity strategists at Morgan Stanley and Bank of America Merrill Lynch have divergent outlooks for where US stocks go next.
- Their point of departure is about whether or not stocks, having regained new highs, will melt up from here.
- Despite their differences, the two firms advised a similar action plan that should be on the radar of anyone who is bullish about stocks.
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With US stocks back at all-time highs and the economy darting ahead, the question on many investors’ minds is "what next?"
Strategists at Morgan Stanley and Bank of America Merrill Lynch have provided contrasting responses to that important question.
Despite their differences, their arguments revolve around one possibility: a so-called melt-up, which happens when investors rush to buy stocks during a rally out of fear of missing out on the ongoing gains.
The most important condition they both cite for this scenario is the Federal Reserve, arguably the single biggest cause of the December correction and the recovery that followed. The central bank doesn’t see any alarming signs of inflation, so it’s in no hurry to raise interest rates — much to the delight of investors.
However, both firms had a similar actionable recommendation: hedge a melt-up. Even BAML, which is firmly in the bullish camp, is advising a barbell-like trading strategy that wagers on a melt-up on one hand, and insures a correction on the other.
Here’s where the two firms stand.
Bank of America: ‘A melt-up of our time’
Besides the Fed’s dovish stance, the firm is bullish because two other big sources of concern for investors have been temporarily pushed to the sidelines: the US-China trade war and Brexit.
The firm’s strategists are also watching what large investors are doing with their money. After all, there needs to be a pile of dry powder at the ready to create a melt-up.
That’s exactly what’s happening: investors have pulled money from equity funds on net for seven straight weeks — including $7.1 billion from mutual funds — according to BAML’s data.
Michael Hartnett, the firm’s chief investment strategist, sees this very trend as one of the reasons why the S&P 500 could soon blow past 3,000. The "bottom line is flows appear to continue to reflect rising investor conviction that central banks will never hike interest rates ever again," Hartnett said in a recent note to clients that he titled "A Melt-up of Our Time."
Morgan Stanley: ‘A few missing ingredients’
The firm’s strategists are braced for a melt-up — but not in the US.
"History tells us that an accommodative Fed and falling rates support the case for a melt-up," Adam Virgadamo, an equity strategist, said in a note to clients.
"However, we also see a few missing ingredients such as an uptick in earnings and economic growth expectations, fiscal relief, investor fear/bearishness and further increases in consumer confidence."
Diving into some of those specifics, he wrote that gross domestic product and earnings growth were higher during prior melt-ups, especially in the 1990s. Also, consumer confidence tends to rise during such episodes, but he doesn’t consider a repeat likely given its already elevated level.
The bull case for markets outside the US is as follows: China’s economic weakness in the first quarter corresponded to poor growth in the rest of Asia and Europe. If Chinese policy stimulus gains more traction and the Fed remains dovish, it would bode well for the other regions.
The bottom line, and what you can do about it
Despite their differences of opinion about what happens next, both firms had the same recommendation: proceed with caution.
Bank of America’s derivatives analysts advised buying short-dated S&P 500 call options that profit from bets the market will continue rallying. But the upshot here, especially for those who also own the underlying stocks, is that these call options are also supposed to limit the downside investors could suffer if there’s a correction.
The options trade recommended by BAML did exactly that during the melt-up in early 2018 and the correction in February.
"Acquiring US equity exposure synthetically via long SPX 1m 40-delta calls would have gained ~7% from Oct. 17 through the Jan. 18 peak in equities (vs. ~12% for an S&P 500 total return investment) while losing less than 2% during the Feb. 18 VIXplosion," Benjamin Bowler, the head of global equity-derivatives research, said in a note.
Morgan Stanley’s strategists, who are more bearish, said that even the possibility of a melt-up is not enough reason to buy US stocks. The better move is to use call options.
"If one is worried about ‘missing’ a melt-up, we think that calls and call spreads are the best way to position for it, rather than adding high-beta stocks," Andrew Sheets, the chief cross-asset strategist, said in a recent client note.
He continued: "And given both our preference for non-US equities and the lower volatility term premiums in these markets (versus the US), longer-dated call options in Europe, Japan and EM look even more attractive."
See Also:
- Bank of America has devised the perfect trading strategy to profit from an imminent melt-up in stocks — one it says will win even if the market plunges
- We talked to 3 experts who explained why the stock market’s latest record is uniquely vulnerable to a sudden downturn
- Investors have rarely been this scared of a stock-market crash over the past 50 years — and that’s flashing some scary parallels to the 1987 meltdown
Source: Business Insider – aoyedele@businessinsider.com (Akin Oyedele)