Uncertainty about the outcome of the Brexit negotiations has hit new highs, President Trump seems determined to scare the markets witless with his threats of escalating the trade war, debt problems in China are accelerating – the perfect background for a contrarian ‘buy’ signal.
It duly arrived last week in the form of Bank of America Merrill Lynch’s “Bull & Bear indicator”, which triggered its first “buy” signal since January.
The indicator fell to 1.3 from 2.4, even lower than in January, when it fell to 1.8 — just a little under the 2.0 level that indicates extreme bearishness and triggers the contrarian “buy” signal.
This time, the decline was driven by outflows from emerging market stock and bond markets, oversold MSCI country indexes and the rapid rally in Treasuries versus corporate bonds.
The Bull & Bear indicator measured cross-asset positioning using 18 indicators for capital flows, sentiment, prices and technical analysis. The last time it triggered a contrarian “sell” signal was in February 2018.
The indicator is relatively young, so it does not have a long track record, but judging by data published by Bank of America Merrill Lynch, it has often been quite accurate.
Median three-month returns from the 16 “buy” signals triggered since the year 2000 have been as follows: global stocks up 6.3%, 10-year Treasury yields up 50 basis points (0.5 percentage points), stocks outperform investment grade bonds by 1050 basis points, high yield bonds outperform government bonds by 650 basis points.
Looking specifically at the hit ratio, the Bull & Bear indicator has been most accurate when it comes to the bond market: on 16 out of 16 occasions, it correctly predicted rising 10-year Treasury yields, high yield bonds outperforming government bonds and stocks outperforming investment grade bonds. However, the indicator’s prediction that global stocks would rise was correct only 10 out of 16 times.
If the prediction turns out to be correct this time, the analysts at Bank of America Merrill Lynch are bullish on stocks and commodities for the short term, due to bearish positioning and loose monetary policies.
For September, they favour the Hang Seng, KOSPI and DAX indices, as well as European banks, noting that US stocks are at 70-year highs versus Europe just as European fiscal stimulus is very likely. They expect the S&P 500 to lag an equity rally and believe 30-year Treasuries are the most vulnerable to a risk-on trade.
For next year, however, they are bearish and see a “big top” in corporate bonds and stocks prices because of risks or a recession, “policy impotence”, and bond bubble risks. This is why any selloff in precious metals such as gold and silver in September should be seen as an entry point.