Rate-Cut Signals Bolster Buy-And-Hold Strategies

By Michael Miska, Bloomberg Markets Reporter and strategist

Stock market optimism is at full throttle after central banks’ rate-cut reassurances, leaving investors with no reason to sell and bears with little to do but await catalysts that might derail this rally.

The Federal Reserve’s signal that three interest-rate cuts are still on the cards for this year has just propelled Europe’s Stoxx 600 index to its ninth straight week of gains, the longest winning streak in 12 years. While the Stoxx and its blue-chip counterpart the Euro Stoxx 50 may look a tad overbought, there is no real sign of the excesses that would trigger technical red flags.

“The Fed delivered the best possible speech for equities,” DayByDay technical analyst Valerie Gastaldy says. Short-and-long trends are still bullish, implying that most bad news will be quickly overcome and new highs will be scaled, she adds. “No method can beat the buy-and-hold in those periods.”

While it may seem like markets are overheating, in fact less than 30% of Stoxx 600 constituents currently look overbought, below the threshold that has signaled exuberance over the past 10 years.

That leaves scope for further gains, especially after last week’s central bank green light. The Bank of England’s meeting outcome gave traders confidence that policy-easing could start June, the same month as the European Central Bank. Switzerland has already made its move. And the Fed indicated it’s willing to look past strong economic data that had raised the prospect of a further rate-cut delay.

That’s a “Fed put” in play, for Barclays strategist Emmanuel Cau. “The Fed communication clearly suggests it wants to cut rates, which tilts the risk-reward positively for risk markets,” Cau says. “History shows that when central banks’ cuts come without a recession ensuing, like in 1995, it typically puts us into a ‘mid-cycle’ situation: the economic cycle tends to get extended as growth is stimulated by the cuts.”

Which is not to say markets are not vulnerable to short-term setbacks. For one, elevated positioning of systematic strategies could be seen as a contrarian indicator. Volatility skew at ultra-low levels suggests there is no appetite for hedging, in itself a potential risk. Current bull/bear and call-to-put option premiums, together with low intraday correlations, hint at abnormally optimistic sentiment, bordering on complacency, according to UBS strategists led by Andrew Garthwaite.

“Our aggregate tactical indicators are extreme and at levels where the market normally falls modestly,” Garthwaite says, citing the most overbought areas, such as construction materials and capital goods, as likely the most vulnerable. Yet according to the UBS model, there is only a small chance of a retracement greater than 5%. “We don’t see this as being a major correction,” he adds.

Given the amount of time that’s passed without a market pullback, the likelihood of a “down week” soon looks pretty high, reckons Carl Dooley, the head of EMEA trading at TD Cowen. But while agreeing that some warning signals are flashing, Dooley expects bears to remain on the backfoot. The reason? “Zooming out, I think shorting a new all-time high continues to be the more dangerous play,” he says.