The stock market looks like a runaway train right now compared to other asset classes. And while investors with dollar signs in their eyes may view the situation as a positive, Wall Street doesn’t like what it sees.
At the root of the concern felt by Goldman Sachs is the disconnect that’s growing between the equity and credit markets. The firm is specifically focused on US investment grade credit, which it notes has been selling off, even as stocks have continued to churn higher.
If this doesn’t strike fear in your heart, consider that the last time the US credit market underperformed stocks to this extent was in late January, mere days before the correction that rocked major indices. As such, Goldman is suggesting clients scale back the equity holdings in their portfolios ahead of what could be a turbulent summer.
Over the past year, when credit lagged stocks by an average of one standard deviation over a 2-, 4-, 6-, and 8-week period, equities then slid an average of 2.3% over the following month, according to Goldman data. On the flipside, when credit beat equities to the same degree, stocks rose 2.4% over the subsequent month.
“We see this difference as significant and leads us to favor de-risking strategies in equities,” a group of Goldman strategists led by John Marshall wrote in a client note.
It’s a view also shared by Bank of America Merrill Lynch, which expressed concern over so-called credit tremors in a report late last week. Current market conditions remind the firm of the environment back in 1998 — a period marked by risk aversion as global contagion stemming from an Asian market meltdown shook investors to their very core.
BAML is more specific in its de-risking recommendation, however, placing the onus firmly on tech stocks. It notes red-hot investor demand for the tech space, citing $2.3 billion of inflows over the past week, the second-most on record. In the firm’s mind, the fervor is getting out of hand.
“The big risk is, as in 1998, that credit tremors spread and investors are forged to de-leverage from risk assets and raise cash,” BAML chief investment strategist Michael Hartnett wrote to clients. “The biggest risk is a quick, deep tech selloff.”
“Bad summer news for risk assets,” he continued. “We remain defensive and happy to sell risk assets into strength.”
The chart below shows the degree to which US stocks have experienced a “conscious decoupling” from the rest of the world. Note that since tech stocks make up such a big portion of the US market, any criticism of the broader complex is, by extension, an anti-tech argument.
If BAML’s summer warning sounds familiar, it’s because the firm’s volatility strategy team issued a different one just a couple weeks ago. Among other troubling developments, the analysts noted that open interest in call options betting on a spike in price swings had surged.
Put differently, as of late May, traders were already piling into wagers that the Cboe Volatility Index (VIX) would spike back up to recent highs by midsummer. And since the fear gauge trades inversely to the S&P 500 roughly 80% of the time, that could accompany a rough patch for stocks, as it did earlier this year.
In the end, the fact that these market pressures are being identified and publicized is encouraging to the degree that investors follow expert advice and scale back US stock holdings.
But as history has shown time and time again, market participants are often unable to resist the temptation of further gains, even if they know it could all come crashing down at any moment. And for that reason, all bets are off. Stay tuned.
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