Further signs of strain in the credit market risks provoking another broad equities rout as long-only investors, including pension funds, will be compelled to sell, according to strategists at Bank of America Corp.
“If private lending hiccups continue, pensions etc. may be forced sellers of index funds to avoid punitive private asset marks and meet ongoing obligations,” said Savita Subramanian, head of US equity and quantitative strategy at BofA Securities. Passive investment “dominates the S&P 500,” so a downturn would push funds that track indexes to sell equities, she wrote in a note Monday.
The warning comes as traders’ worries are mounting that bad loans at smaller banks are poised to spill over into other corners of the stock market. An index of regional lenders fell more than 6% on Thursday and have slumped for four straight weeks, the longest slide of the year.
BofA isn’t alone in warning about valuations and the potential for continued selling pressure from index-tracking funds. Miller Tabak + Co.’s Chief Market Strategist Matt Maley said that exchange-traded funds tracking the banks could compound selling.
“Given that the bank ETFs have already been under some material weakness, it’s not going to take much downside follow-through to confirm an important change of trend in the bank stocks,” he wrote.
Amid the risks of forced selling by pension funds, Subramanian urged investors to “be selective.”
In addition to credit risks, BofA said there are increasing valuation risks to to the three-year-old bull market as the S&P 500 Index is “statistically expensive” across 20 different value metrics. Meanwhile the odds of a market downturn are rising.
“Our bear market signposts — the triggers that typically precede an S&P 500 peak — suggest additional caution,” Subramanian wrote. She noted that six of 10 bear market warning signs that the bank watches have been triggered. Typically, an average of 70% of those signs are set off before the market hits a peak and begins an extended decline.
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