Icarus needs to buy a parachute
Analysts at Bank of America Merrill Lynch (BofA ML) have for some time now been calling the global rally in equities the “Icarus trade”, referring, in case you’ve forgotten your Greek mythology, to the chap who flew on wings made of feathers glued together with wax. Unmindful of warnings, he flew too close to the sun, which made the wax melt and he plummeted to his doom. It’s a parable of hubris and the nemesis that inevitably follows, handy for dire warnings about the stock market.
Back in February this year, when BofA ML headlined its survey Icarus Takes Flight, a net 26% of the global fund managers surveyed said they thought equities were overvalued and they accordingly kept 4.9% of their portfolio in cash.
Nine months later, in November 2017, the cash is down to 4.4% (the lowest level since October 2013), in spite of a net 48% (a record high) of fund managers saying equities are overvalued. At the same time, the net overweight of fund managers in equities is the highest since April 2015.
It is this combination of the rise in the number of investors believing that equities are overvalued with lower cash levels that the BofA ML survey says is “irrational exuberance”. For why, if you think equities are overvalued, should you put more cash in the market? “Icarus is flying ever closer to the sun,” said Michael Hartnett, chief investment strategist at BofA ML.
The number of fund managers in the survey taking higher-than- normal risks is at an all-time high, the proportion of fund managers believing in the Goldilocks scenario of above-trend growth and below-trend inflation is at a record high, hedge fund allocation to emerging markets is at an 11-year high. Back in February, only 18% believed in Goldilocks. For all these reasons, the survey believes bull capitulation is nigh.
Yet, the survey says a sell signal has not yet been triggered and cash levels need to drop further. Could there be a rational basis for the exuberance?
A clue is provided by the JPMorgan Global Composite Purchasing Managers’ Index (PMI), a snapshot of private sector business activity in both manufacturing and services across the world, which has been seeing good growth.
David Hensley, director of global economic coordination at JPMorgan, said of the October PMI: “The global economy is maintaining its solid and steady growth path. Signs that price inflation eased should provide some respite to firms and ensure cost pressures will not constrain growth in the months ahead.”
So what should Icarus do? He should buy himself a parachute. Investors should take out hedges against their long equity positions by buying put options or shorting futures or putting some money into liquid funds as well as diversify their positions.
That way, when his wings fall off, Icarus could waft gently to earth. He may even walk away unscathed.