Have you heard the good news?
There’s a “melt-up” coming and it’s part and parcel of a “blow-off top” in stocks.
I know this because CNBC anchors with Twitter accounts told me about it. They also said the only way to play it is to pile into ETFs so that I can ensure I have absolutely no downside protection in the event something goes wrong. The other thing they told me is that people who don’t position for this melt-up using straight-up, balls-to-the-wall, tech ETF exposure are drug-addicted goblins who are out to pilfer my money and maybe even murder me and my family as we sleep.
Here’s what we said a couple of weeks ago about this:
Of course at this point, I’m not really sure what counts as a “blowoff” top.
That term has been bandied about ceaselessly of late, and there are plenty of folks who will tell you they can define it, but that’s silly. It’s a Trump-ish superlative like “tremendous,” or “phenomenal,” or “big league.” Same goes for “melt-up.” What the hell is a “melt-up,” exactly, if not what we’ve been seeing every single day for years? I don’t know. And contrary to what they’ll tell you, neither does anyone else.
“Later stages of bull markets are dominated by sentiment rather than valuations,” Bloomberg’s Tanvir Sandhu wrote last month. Duly noted, but please point me to a time over the last year when it would have been plausible to say that valuations at the index level were some semblance of compelling, because I must have been off the desk that day.
Implicit in that is the notion that to the extent a “melt-up” is a real thing, it’s already happened folks. And sure, things could always get “melt-up-ier” and then I guess “melt-up-iest“, but again, at that point you’re playing Mad Libs with Trump.
Well, guess what? BofAML agrees with the sentiment that we’ve already seen the melt-up – or at least in risk-adjusted returns. To wit:
A melt-up in US equity Sharpe Ratios: Over the past 12 months, the Dow Jones Industrial Average has rallied nearly 29% (not including dividends) on 7% realized volatility, good for a Sharpe Ratio of 4 (Chart 7). Since 1935, the 12M Sharpe Ratio of the Dow has been higher only 1% of the time.
Similarly, the S&P 500 has recorded a Sharpe of 2.8 over the past 12 months (96th percentile; Chart 8) while generating a relatively pedestrian 12M return of 21% (77th percentile; Chart 8). Moreover, with a 12M Sharpe of 2.5, the Nasdaq 100 is approaching Tech Bubble peaks in risk-adjusted returns despite nominal returns only ¼ as large.
And of course this is down to vol.:
Ultra-low vol turning good equity returns into historically great Sharpes: The common factors transforming today’s good equity returns into stellar Sharpe Ratios? Historically low equity volatility and interest rates. Chart 9 isolates all historical 12M periods since 1935 in which the S&P 500 recorded a Sharpe Ratio of at least 2.8 (= S&P Sharpe over the past 12M). Among these “high Sharpe” periods for US equities, the most recent 12M period has witnessed the lowest S&P 500 price return and nearly the lowest realized volatility in history. The last historical period with higher S&P 500 Sharpe Ratios was the mid-1990s (Chart 9); while realized volatility was also in the single digits, this occurred against a different macro backdrop of flat to falling short-term interest rates (Chart 11). One has to go back to the early-1960s to find a period with (i) Sharpe Ratios exceeding today’s levels, (ii) equity volatility as low or even lower on a sustained basis, and (iii) a gently rising rates cycle (Chart 10)
So what does that mean going forward, assuming you want to stick around and bet on a continuation of this madness? Well, here’s what we said on Monday:
Meanwhile, people are advocating that you participate in the last leg of one of the longest-running rallies in market history not by selectively choosing stocks, or by replacing equity exposure with cheap calls, but rather by blindly funneling money into ETFs. It’s literally the worst advice imaginable and it is so wildly irresponsible that it boggles the mind.
Right. And here’s what BofAML says in the same note cited above:
Interestingly, the mid-1990s and mid-1960s featured the three longest streaks on record of consecutive trading sessions without a 5% or more pull-back in the S&P 500 (the current streak of 339 days is fourth-longest). Curiously, the eventual 10% sell-off that ended the 387-day streak in June-1965 seemed largely driven by sentiment rather than fundamentals. Given today’s equity Sharpe Ratios are in “rarefied air”, we continue to advocate using historically cheap options to capture upside with less risk.
See? But what do we know and what does BofAML’s global equity derivatives team know, right?
Now go back to your Twitter feed and read about how you should buy more QQQ.