Wall St: Stock surge is a bear-market trap with curve inverted, warns BofA

The 11% surge in US stocks in the past two weeks has the hallmarks of a bear-market rally that might give way to deeper losses. That’s the conclusion of analysts at Bank of America, who say warning signs are flashing for a market that has climbed “despite clearly weaker fundamentals,” including a Federal Reserve bent on raising rates sharply this year to battle persistent inflation.
 

The strategists caution that the selloff that took the S&P 500 12% from its January record is not over and sharp rallies are typical of volatility in bear markets, with some of the biggest on record occurring in the throes of the dot-com meltdown and the global financial crisis.

A closely watched Treasury market metric flashed a recession warning Tuesday, adding to worries a restrictive Fed will damage the economy.
 

“The worsening macro backdrop and market-unfriendly Fed make sustained U.S. equity gains unlikely,” strategists including Gonzalo Asis and Riddhi Prasad wrote. The Fed isn’t likely to come to the market’s rescue at any point and, in fact, the central bank is welcoming of tighter financial conditions to aid its battle against inflation. “In practice, this means lower risk assets.”
 

For now, investors aren’t heeding any warnings. The S&P 500 jumped 1.2% Tuesday for its ninth gain in 11 sessions, even as the yield on two-year Treasuries popped above the 10-year rate for the first time since 2019.
 

But 10-day stretches of big gains have been common in bear markets. There were four that exceeded the 10-day rally of 10% through Monday in 11 bear markets since 1927, the BofA strategists wrote.
 

It’s not hard to find reasons for caution. The war in Ukraine still has commodity markets in turmoil, with fertilizer the latest product to skyrocket in price. Oil prices are still elevated, adding to inflationary pressures the Fed has promised to tamp down, even if it damages demand.
 

The strategists recommend investors sell out-of-the-money calls to hedge against both downturns as well as any potential short-term run-ups, which they say will be “limited.”
 

Bulls argue that despite the Fed’s push to slow growth, companies will still be able to deliver profit gains that justify valuations. Corporate America, in particular, is most insulated from the impact of sanctions on Russia, at the same time that bonds around the world have been in freefall.
 

BofA’s strategists said it would take softer inflation for stocks to be able to add to the latest gains -- something the bank’s economists don’t expect. They also warn that any easing of tensions in eastern Europe would remove a threat to growth but also give the Fed cover to hike faster.
 

The rates markets, for one, are exhibiting a lot more signs of stress. An increase in rates volatility over the past 10 days, as measured by the MOVE Index, relative to falling equity-markets volatility, as measured by the VIX, has been the largest since 2009 and is one of the biggest ever, BofA says. Following the 2009 episode, the S&P 500 fell 7% over the following six weeks.
 

Stocks registered a big pullback at the start of the year, and investors are now wondering if the market’s mired in a bear market. “We believe so,” Katerina Simonetti, senior vice president at Morgan Stanley Private Wealth Management, said in a Bloomberg Radio interview.
 

“We believe that yes, in fact, this is a bear market, we have been in a bear market for quite some time,” she said. Her team came into the year worried about valuations, Fed tightening, inflation and a growth slowdown, and the war in Ukraine worsens many of those concerns.
 

“Now, this is not to say that there are no pockets of opportunity in this market, there absolutely are, and investors should be in position to take advantage of them,” Simonetti said. “But they are bear market rallies and they have to be seen as such.”