Don’t let the calmest market in years lull you to sleep.
While a gauge of volatility spanning multiple asset classes has slipped to its lowest level since 2014, a separate measure of market fragility has been climbing steadily over the past six months, according to Bank of America Merrill Lynch.
The so-called “Fragility Indicator,” maintained by BAML, is designed to measure the frequency and extent to which volatility measures and credit spreads are seeing abnormally large shocks. And it’s climbed roughly 50% since October.
This is notable because the last three times the fragility gauge rose sharply — in the second half of 2007, first half of 2011 and second half of 2014 — it preceded drawdowns from hedge funds, according to BAML.
Hedge funds are particularly significant in this situation because it’s their investment activity that’s led to crowded positioning across multiple asset classes. If faced with an unexpected shock, these funds would be forced to endure a painful unwinding as everyone rushes for the exit simultaneously.
“Markets today are prone to ‘flash crashes’ and tantrums,” the BAML equity derivatives team wrote in a client note on Tuesday. “Rising fragility shows cracks emerging.”
So is it time to start piling into hedges? Not quite yet, says BAML.
They found that the recent rise in the Fragility Indicator has mostly been driven by volatility in commodities — most notably oil, gold, and copper.
As such, any major unwind would occur only after other asset classes see increased price swings and uncertain sentiment. In the mean time, the firm advises stock investors to sit tight as the S&P 500 stays range-bound through the summer.
That matches expectations across Wall Street. Strategists across 19 firms see the S&P 500 ending the year at 2,414, less than 0.1% from last Friday’s close.