Here Are The 7 Rules Bank Of America Uses To Decide When It Is Time To Sell The Market

With the Trumflation rally fizzling with every passing day, the only question asked by traders is “Is it time to sell the market?” According to Bank of America, the answer, at least for now, is no.

That’s the conclusion of BofA’s chief investment strategist Michael Hartnett who looks at the bank’s 7 favorite, proprietary market-timing indicators, and finds that, at least based on historical patterns, the major selling is not imminent, adding that “we remain bullish risk assets; “3P’s”, Positioning, Profits & Policy, drive our tactical & cyclical views; our latest Rules & Tools piece shows Positioning has become more bullish but not yet dangerously euphoric.” He finds that according to his market-timing indicators, the next step is the opposite, and the current rally will end “with one last 10% melt-up in stocks & commodities in 2017.“

Here is how Hartnett lays out his “rules” to quantify market fear and greed: 

“Our rules can help identify major inflection points in market cycles. We track a broad array of positioning, sentiment, and flow data that signal when global equities are likely to peak or trough. For example, our Global Breadth Rule measures oversold conditions across global markets, and our Bull & Bear Indicator tracks 18 different indicators of flows and positioning.”

Harnett summarizes the 7 rules and indicators he uses as folows (more details below):

• BofAML Bull & Bear Indicator is our broadest measure of investor sentiment; readings range from 0-10; currently at 6.1; indicator still shy of “sell” trigger of 8.0.
• Global FMS Cash Rule measures institutional cash levels as gauge of fear & greed; currently at 5.1% (above “buy” threshold of 4.5%), i.e. indicator in “buy” territory.
• Global FMS Macro Indicator augments our existing Cash Rule with a filter for macro momentum; currently in “buy” territory as macro momentum trending higher past 6 months & cash levels higher past 2 months.
• Global Breadth Rule has flipped from net 89% of equity markets being oversold in Jan’16 (“buy” signal triggered) to net 76% of equity markets being overbought today; breadth rule closest to exuberance.
• Global Flow Trading Rule uses flows to global equity and HY bond funds as contrarian indicator of risk appetite; currently neutral territory (flirted with “sell” signal in Dec’16).
• EM Flow Trading Rule uses flows to EM equity funds as a contrarian indicator of risk appetite; currently neutral.
• BofAML MVP Model is a long/short strategy that selects countries based on the three factors of Momentum, Value & Profits; currently “long” France, Sweden & UK, paired with “shorts” in Brazil, Norway & Singapore.

Harnett notes that BofA’s indicators also give tactical signals when fundamentals are silent, such as within range-bound markets or during periods when economic data paint a conflicted picture. Table 2 offers a quick summary of the latest signals & readings:

Before we dig into the details behind of the 7 indicators, here are the three take home lessons from applying the bank’s timing rules:

1. Structural market changes are more important than ever. Flow and positioning data help identify the impact of new market entrants, newly active participants (e.g. risk parity and quantitative funds), and the increasing prevalence of cross-asset mandates.
2. It’s better to be buying. Our research shows that measuring fear is easier than measuring greed, and that market tops tend to be a process, whereas market bottoms form quickly. As a result, “buy” conditions are often more visible than occasions to “sell short” in our view.
3. It’s okay to assume some normality. Measuring overbought and oversold conditions works best when markets behave in line with history. For example, our meanreverting Global Breadth Rule functions better for trading conditions within one standard deviation than with >2 deviation conditions, e.g. conditions associated with the global financial crisis.

So with that said, here are the details, together with the current reading:

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BofAML Bull & Bear Indicator – Neutral

The rule:

• Sell risk assets when the Bull & Bear Indicator exceeds the “greed” threshold of 8.0.
• Buy risk assets when the Bull & Bear Indicator falls below the “fear” threshold of 2.0.

What is it?

The BofAML Bull & Bear Indicator is a proprietary cross-asset barometer that uses fund flows, positioning data & market technicals to quantify investor sentiment. The indicator is max bullish when it reaches 10 and max bearish when it reaches 0.

Latest signal

BofAML Bull & Bear Indicator climbs to 2.5-year highs (6.1 – Chart 1) as equity/credit market breadth improves & inflows return to EM debt & equity funds. But indicator is still shy of “sell” trigger of 8.0. Last contrarian “buy” signal for risk assets triggered on 6/28/16 when sentiment fell to an “extreme bearish” reading of 2.0. Global equities rallied 8.1% over the subsequent three months.

Components

• Flows: investor risk appetite as indicated by flows to EM equity funds, EM debt funds and high-yield bond funds
• Positioning: investor risk exposure as measured by long-only fund manager cash levels, equity vs bond allocation, cyclical vs defensive sector allocation and futures positioning across fixed income, commodities, FX and equities
• Price action: market technicals implied by global equity market breadth & relative performance of credit to US treasuries

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BofAML Global FMS Cash Rule – Bullish

The rule

• Buy equities when the FMS average cash balance rises to 4.5% or higher
• Sell equities when the FMS average cash balance falls to 3.5% or lower

What is it?

The BofAML Fund Manager Survey (FMS) is a monthly survey of 200-250 primarily long-only investors. One of the key questions in this survey asks for cash balance as % of assets under management.

A low cash balance indicates investors are vulnerable to negative market shocks, while a high cash balance means investors could be under-invested & vulnerable to positive market shocks.

Latest signal

Cash inched higher to 5.1% in Jan’17 from 4.8% last month. Current reading remains elevated vs its 15-year history and overall FMS does not yet show “peak greed”. Rule stays in “buy” territory.

A critical look at the Global FMS Cash Rule

The Global FMS Cash Rule has been a reliable barometer of risk appetite since we first introduced it back in 2011. After a contrarian “buy” signal is triggered, the median return for US equities is 1.0% over the next month, 1.4% over the next two months and 2.9% over the next three months. Likewise, after a contrarian “sell” signal is triggered, the median loss for US equities is -0.5% over next three weeks, -3.5% over next four weeks and -2.6% over next five weeks. In short, the simple “buy” (>4.5%) and “sell” (<3.5%) thresholds have provided us with faithful tactical recommendations over the years.

But cash levels have remained elevated ever since the May’13 “taper tantrum” with cash rarely dipping below 4.5%. As a result, the rule has been in persistent “buy” territory since Nov’13, behaving less like a tactical indicator and more like a cyclical indicator over the past three years.

Over the past few months, we have asked survey participants for reasons why they are holding consistently higher levels of cash in recent quarters.

• On average, 53% simply cited their “bearish views on markets”
• 47% listed either structural factors (regulatory/industry changes, higher derivatives costs & margin requirements) or preference for cash over low-yielding equivalents

We believe that the May’13 “taper tantrum” has awakened investors to the risk that the central bank-induced “long duration/yield” trade is vulnerable to violent unwinds from either a “bond shock” and/or faster-than-expected policy normalization. As a result, investors are holding higher-than-normal cash as an insurance policy even though their inflation expectations are high, capex demand is strong and positioning in cyclical vs defensive sectors is rapidly improving (Chart 5)

In light of the structural/technical factors noted above, we present an alternate rule called the BofAML Global FMS Macro Indicator to complement our analysis on cash.

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BofAML Global FMS Macro Indicator – Bullish

The rule

• Buy global equities when Global FMS Macro is improving and cash level is rising relative to past two months
• Sell global equities when Global FMS Macro is deteriorating and cash level has fallen by at least 50bp relative to past two months

What is it?

The BofAML Fund Manager Survey (FMS) is a monthly survey of 200-250 primarily long-only investors.

The FMS Macro Indicator is a year-on-year measure that comprises five components: investor inflation expectations, capex demand, risk appetite, cyclicals vs defensive^ sector positioning and equity vs bond positioning. ^ cyclicals = industrials, materials & tech; defensive = staples, telcos & utilities

Latest signal

The Global FMS Macro Indicator augments our existing Cash Rule with a filter for macro momentum. It is currently in “buy” territory as FMS Macro has been trending higher for the past 6 months and Jan’17 cash level is higher than it was two months ago. This is a bullish combo for risk assets because investors have been reluctant to deploy cash even though FMS Macro is positive and clearly on the upswing (Chart 6).

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BofAML Global Breadth Rule – Neutral

The rule

• Buy global equities when a net 88% of markets in the MSCI All Country World Index are trading below both their 200-day moving average and 50-day moving average.

What is it?

The BofAML Global Breadth Rule is a contrarian indicator of equity market breadth. When an overwhelming majority of equity markets around the world become oversold, we turn bullish as equities tend to trough and rebound on the back of overdone pessimism.

Latest signal

Our BofAML Global Breadth Rule shows that a net 76% of equity markets are currently trading above both their 200- & 50dma. Market breadth is at 5-month highs and edging closer to exuberance. This is a dramatic flip from Jan’16, when a contrarian “buy” signal was triggered after net 89% of global equity markets had tumbled below their 200- & 50-dma (Chart 9). Back then, global equities declined another 5.5% initially, before rallying back to +3.5% within three months.

The Global Breadth Rule is our favorite indicator for timing market-entry following a sell-off in global equities. As with most tactical trading rules that rely on short-term mean-reverting tendencies of asset markets, it would not work during sell-offs that are >2 standard deviations in nature, i.e. 2008 Global Financial Crisis.

Notwithstanding the Global Financial Crisis, we examined the return distribution of MSCI ACWI at different “buy” thresholds. Chart 10 suggests that the probability of an outsized 3-month return is much higher and the probability of negative return is minimized when at least a net 88% of equity markets are already trading below their 200dma and 50dma.

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BofAML Global Flow Trading Rule – Neutral

The rule

• Sell global equities when average inflows to global equity funds and global HY bond funds exceed 1.0% of AUM over four weeks and ISM is trending lower.
• Buy global equities when average redemptions from global equity funds and global HY bond funds exceed 1.0% of AUM over four weeks and ISM is trending higher.

What is it?

The BofAML Global Flow Trading Rule combines cross-asset flows with a validating filter for macro conditions to generate buy & sell signals for global equities. When flows into global equity & HY bond funds become overly bullish especially against a backdrop of weaker PMI, risk assets become vulnerable to short-term tactical pullbacks and vice versa. Data source: EPFR Global, which tracks institutional & individual investor flows to mutual funds & ETFs domiciled globally with $24 trillion in total assets

Latest signal

Our Global Flow Trading rule is in neutral territory as 4-week inflows to equity funds & HY bond funds = 0.6% of AUM. The rule flirted with a contrarian “sell” signal in mid- Dec’16 as 4-week inflows reached 1.0% of AUM. But ISM and PMIs globally were all trending higher (strengthening) then, allaying concerns over exuberant fund inflows. The trading rule also came very close to a contrarian “buy” signal for global equities in Jun’16 when 4-week outflows reached 0.9% of AUM (Chart 11).

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BofAML EM Flow Trading Rule – Neutral

The rule

• Sell EM equities when inflows into EM equity funds represent more than 1.5% of AUM over four weeks.
• Buy EM equities when redemptions from EM equity funds are greater than 3.0% of AUM over four weeks.

What is it?

On a weekly basis we analyze data on total flows into and out of EM long-only funds and ETFs. Flows tend to coincide with (rather than lead) performance and are therefore well-suited for use as a contrarian indicator. When investor flows into EM funds become overly bullish, EM equities become vulnerable to short-term tactical pull-backs and vice versa. Data source: EPFR Global, which tracks institutional & individual investor flows to mutual funds & ETFs domiciled globally with $24 trillion in total assets.

Latest signal

Our EM flow trading rule is also in neutral territory as 4-week inflows = 0.3% of AUM. It last triggered a “buy” signal for EM equities on 9/3/15 when 4-week outflows reached 3.0% of AUM (Chart 12). MSCI EM fell another 2.5% initially, before rallying 5.6% on an 8-week basis.

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BofAML EM Flow Trading Rule – Neutral

The rule

• Sell EM equities when inflows into EM equity funds represent more than 1.5% of AUM over four weeks.
• Buy EM equities when redemptions from EM equity funds are greater than 3.0% of AUM over four weeks.

What is it?

On a weekly basis we analyze data on total flows into and out of EM long-only funds and ETFs. Flows tend to coincide with (rather than lead) performance and are therefore well-suited for use as a contrarian indicator. When investor flows into EM funds become overly bullish, EM equities become vulnerable to short-term tactical pull-backs and vice versa. Data source: EPFR Global, which tracks institutional & individual investor flows to mutual funds & ETFs domiciled globally with $24 trillion in total assets.

Latest signal

Our EM flow trading rule is also in neutral territory as 4-week inflows = 0.3% of AUM. It last triggered a “buy” signal for EM equities on 9/3/15 when 4-week outflows reached 3.0% of AUM (Chart 12). MSCI EM fell another 2.5% initially, before rallying 5.6% on an 8-week basis.

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BofAML MVP Model

The model

Our new long/short BofAML MVP model selects equity markets based on the three factors of Momentum, Value & Profits (Chart 14). We believe a long/short strategy targeting minimal market risk (beta), lower drawdowns & higher risk-adjusted returns can outperform in a world of low expected returns. For more details on backtest results & methodology, please see link for the launch report.

Latest signal

On a 1-month basis, our BofAML MVP model recommends going “long” an equalweighted equity basket of France, Sweden & UK paired with “shorts” in Brazil, Norway & Singapore.

Model framework

Universe

Our model is based on a 16-country universe comprising MSCI US, Canada, Germany, France, Italy, Spain, Netherlands, Switzerland, Sweden, UK, Norway, Brazil, China, Australia, Japan and Singapore. The 16 countries are chosen based on data availability.

Factors

• Value is represented by price-to-book value from MSCI. Book value is lagged by a month to ensure data availability and the most recent month-end market values are used to compute the ratios.
• Momentum is measured via country flows, a derived dataset from EPFR Global that estimates the overall money flow into different countries by multiplying the net flows for a given fund by the fund’s country allocation. The process is repeated across all funds with relevant investment mandates and then aggregated into a final number. Country flows are lagged by a month due to data availability.
• Profits are proxied by Purchasing Managers’ Indices (PMI) from Markit Group & the ISM, both of whom track sentiment among purchasing managers at manufacturing firms. The index is based on five major indicators: new orders, inventories, production, supply deliveries and employment environment. PMI data are lagged by a month to ensure data availability.

Momentum x Value x Profits

It is well-documented1 that “Factor Investing” – namely, Value, Growth, Size & Momentum – can capture risk premia and outperform the broad market over long periods. But less appreciated is the cyclicality of factor returns to different phases of the business cycle. It is therefore unreasonable to expect a single factor (say high bookto- market ratio) to generate persistent excess returns across the business cycle. We focus on the synergy that exists between Value and Momentum, whose negative correlation with each other acts as a natural buffer against “value-traps” and abrupt “mean-reversions.”

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And two extra bonus long-term market timing signal:

BofAML Global Financial Stress Index

What is it?

The BofA Merrill Lynch Global Financial Stress Index (BofAML GFSI™) and its constituent indices are designed to be a comprehensive measure of financial stress, covering: 1. cross-asset risk measures of volatility, solvency and liquidity (the Risk Index); 2. hedging demand implied by equity and currency option skew (the Skew Index); and 3. investor risk appetite gauged by trading volumes and flows into equities and high yield bonds and out of money markets (the Flow Index). The GFSI and its 11 sub-indices can be followed daily on Bloomberg using the code: GFSI.

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Sell Side Indicator – Neutral

The rule

• Bullish signal: when Wall St is bearish…Sell Side Indicator >1? below the mean
• Bearish signal: when Wall St is bullish…Sell Side Indicator >1? above the mean
• Index target: the indicator can be used to predict +12-month S&P 500 total returns and is one of five input models used by our US Strategy team for their S&P 500 target

What is it?

Our US Equity & Quant Strategist Savita Subramanian’s Sell Side Indicator is based on a survey of Wall Street Strategists that submit asset allocation recommendations to us and/or Bloomberg. The indicator shows the average recommended equity weighting in a balanced fund. A contrarian Buy (Sell) signal is triggered when the indicator is more than 1 standard deviation below (above) its mean on a rolling 15-year basis.

Latest signal… equity sentiment was unchanged in January

In January, the Sell Side Indicator is unchanged at 52.8, staying in “Neutral” territory for a second consecutive month. This follows the biggest two-month increase in optimism since 2013. While sentiment has improved significantly off of the 2012 bottom — when this indicator reached an all-time low of 43.9 — today’s sentiment levels are still below last summer’s high of 54.0 and where they were at the market lows of March 2009. The recent inflection from skepticism to optimism could be the first step toward the market euphoria that we typically see at the end of bull markets and that has been  glaringly absent so far in the cycle.