Back in late 2017, Bank of America's derivatives strategists made a remarkable, if hardly original, observation - the bank said what everyone knew but was afraid to voice namely, that "In Every Market Shock Since 2013 Central Banks Have Stepped In To Protect Markets."
Since then, the market's Pavlovian response to unconditional central bank intervention has gotten so embedded in the collective trader psyche that neither fundamentals, nor adverse news matter any more as everyone is convinced that central banks will step in the moment there is another dip in risk assets. In fact, on Friday another BofA strategist, Michael Hartnett, wrote that in the past 18 months "the Fed has bought $4 trillion bonds, twice the amount the US spent on War in Afghanistan past 20 years as it, and other global central banks, have spent $834 million every hour buying bonds since COVID." Add to this that the US government has spent $875 million every hour in ’21 and one gets a staggering number of $1.7 billion spent between central banks and the US government to prevent even a modest market correction.
As Hartnett put it, "little wonder everyone believes in TINA & BTD."
Little doubt indeed, and that's why we now live in a world where a 1% "drop" in the market is considered a biddable dip.
There is just one problem with this Pavlovian approach to "investing" in manipulated markets: as Bank of America also explained back in 2017, indiscriminate dip-buying leads to unprecedented fragility and risks of a crash so powerful not even the Fed will be able to reverse it.
Incidentally, that was the subtext of observations published yesterday by Goldman's derivatives strategist Rocky Fishman who observed several increasingly alarming trends in the options market, most notably the gaping chasm that has opened between realized and implied vol, not just spot by 1 year forward. As Fishman noted, "the one-year VIX index has risen to 26 — close to the top of its Q2/Q3 range, well above spot, though below its Q1 median of 28." As Fishman noted, "since 1940, the only times the S&P 500 has had realized volatility well above 26 for a full year have been around the 1987 crash, the GFC, and the coronavirus crisis." This means that, all else equal, while stocks may be levitating ever higher on ever lower volumes and ever shrinking breadth, the options market is preparing for a crash similar to those observed on Black Monday, the Global Financial Crisis and the Covid Crash, which wiped out a third of market cap in days.
Of course, one wouldn't know this by looking just at the S&P500 which on Friday again closed just a hair away below its all time high.
Which brings us back to the topic of market fragility, initially popularized by BofA back in 2017 and one which the bank's derivatives team addressed again last week, noting that after the latest ramp higher which is on the verge of breaking core records, "history suggests caution against this calm backdrop, as similar periods of extremely steady grinds higher have preceded large fragility shocks."
As BofA's Benjamin Bowler writes, echoing many of the same observations made by Goldman's Rocky Fishman, "swelling taper talk and the rise of the Delta variant have failed to make a meaningful mark this summer on the US equity market, which continues its steady drift higher at low realized vol." To demonstrate this point, in the chart below Bowler and team show that the S&P has now gone 200 trading days (it was 196 as of Monday) without a 5% pullback, making this the 5th longest streak in 50yrs. Notably, in the post-GFC era, the two previous such streaks both ended in the "large fragility events" of the Aug 2015 yuan devaluation and the Feb 2018 Volmageddon.
Meanwhile, underscoring the complacency in the market, the index is on track to a near-record number of all-time highs in 2021.
Expanding this analysis from stocks to balanced portfolios, BofA notes that the two largest fragility shocks in the history of 60/40 portfolios - Feb-18 and Mar-20 - were both preceded by near record risk-adjusted returns, similar to what we are seeing today, "suggesting momentum chasing and depressed volatility are two of the key drivers of today’s fragile markets." Needless to say, while implied vol may be a somewhat elevated, realized vol is near record lows while momentum chasing... well, just take one look at what happens to any meme stock du jour.
The bottom line, as Bank of America concludes is that "history suggests caution against this calm backdrop, as similar periods of extremely steady grinds higher have preceded large fragility shocks." Echoing what he wrote 4 years ago, Bowler repeats the most important mantra of modern markets, namely that "stability breeds fragility, particularly when (i) the stability is grounded in the tight grip of central banks, who force investors into low-conviction, momentum-driven positions, and (ii) those central banks turn less accommodative, a prospect that is now upon US investors."
Bowler's advice: watch Jackson Hole (26-Aug), August payrolls (3-Sep), and the 22-Sep FOMC meeting for potential risk off catalysts, although as the BofA strategist warns "fragility can also be triggered by seemingly innocuous events" when they reach a point of peak instability, triggering a liquidation cascade.
Our only counterargument here is that even, or rather especially if, stocks indeed crumble as the market instability finally manifests itself into a selloff, the most likely outcome is that the Fed will step in even more forcefully, with many expecting that Powell will buy single stocks and equity ETFs during the next crisis, and thus refuse to sell expecting an even bigger bounce after the next Fed bailout. And since the Fed has now staked its entire reputation on not allowing what was once a market and is now merely a policy vehicle to give the impression that all is well, to crash ever again, these cynical skeptics are likely right inexpecting an even more powerful meltup just after the next crisis strikes.