It’s a fine line between pleasure and pain, and euphoric markets have a penchant for courting and then punishing investors. A so-called pain trade transpires when an unanticipated rise or fall in an asset price gravely damages the performance of consensus-following portfolios. It’s a phenomenon rife with angst, especially when traders and investors must decide, under duress, whether to hold and hope for a rebound or to take a big loss and ditch—inflicting further pain on those who have yet to bolt. It took mere months for the crowded, euphoric bubble trades of 2000 (tech) and 2006 (real estate) to turn into the kings of pain of the ensuing crashes. The tech-heavy Nasdaq and residential property prices have yet to recapture their peak values. Ditto Japanese equities and real estate compared with the go-go days of 1989.
What of the pressure points of 2014? In a note last week to clients, a group of Bank of America Merrill Lynch (BAC) investment strategists led by Michael Hartnett highlighted five pain trades brewing across the decidedly risk-on planet. They start by noting how consensus-minded Wall Street has become: 75 out of 88 economists currently forecast a tight 2.5 percent to 3.2 percent range for U.S. gross domestic product growth this year; 21 out of 21 strategists expect the Standard & Poor’s 500-stock index to end the year above 1,850, where it now trades. “Stocks,” they write, “are at all-time highs; bond and foreign exchange volatility at one-year lows. What could go wrong?”
Hartnett and crew’s potential pain trades:
Pain Trade No. 1: From 666 (the 2009 low of the S&P 500) to 6,666 (where a hot Nasdaq could be headed)
In this scenario, Hartnett and his colleagues see too much money chasing too few hot investments at a time of excess global liquidity, what with central bankers the world over exceedingly accommodative in order to counter European and Asian deflation. This could then swell excess valuations in global tech and health-care stocks, small-cap shares, junk bonds, and real estate markets such as London, Singapore, and Dubai that cash-rich foreigners are increasingly regarding as “safe havens” for their restive, zero-yielding cash. “In our view,” the strategists write, “we are not there yet.” If we were, they argue by way of a heads-up to investors, breadth within the stock market would be narrowing, much as it did into the tech bubble and the bear markets of 1990 and 1974.
Pain Trade No. 2: Italy’s 10-year trades below 1.5 percent by 2015
“Capital,” write Hartnett & Co., “ruthlessly gravitates to wherever easy money and tough reform is enacted.” Amazingly, although Spain arguably remains in a depression with high unemployment, its banks cored out and seized, and workers taking punishing pay cuts, Spanish bond yields are now just a fraction of a point away from 200-year lows. For all of Italy’s overleveraged torpor, its 10-year bonds are not far off lows they haven’t seen since 1945.
Since Mario Draghi’s July 2012 pledge to do “whatever it takes” to rescue Europe, the rally in peripheral European economies’ debt and equities has been almost relentless. Is that too much too soon? How quickly people forgot the severity of euro zone crisis, which emanated from Greece to the peripheral likes of Portugal, Ireland, Italy, and Spain. What if Russia’s adventures in Crimea spill over into something systemic?
Pain Trade No. 3: Japanese land prices rise
The BofA Merrill strategists observe that last year’s wild enthusiasm for the asset-price reflation of Abenomics seems to have dimmed so far this year, with Japan’s Nikkei stock average underperforming most other global benchmarks. But this new pessimism, which might have been a helpful pause after such a whiplashing runup in risk assets, could be reversed if the Japanese land market, comatose for the better part of 25 years, starts to show signs of life. “We believe the negative drag to domestic investor, consumer and business animal spirits cannot be exaggerated,” writes Hartnett and his colleagues. “Imagine buying a house or a plot of land in 1991 for $100,000, and seeing its value fall in the next 22 years to $42,000. That’s the reality in Japan. We think rising land prices, so paramount to any escape from debt deflation, can bring them back.” Would such a jump in land prices bait Japanese banks and investors into another generational pain trade?
Pain Trade No. 4: Some emerging markets outperform
Hartnett and his colleagues worry that there could be a pain trade brewing in emerging markets, to the extent that most of the sector remains out of favor with investors thanks to headline laggards Russia, China, and Brazil, the stalwarts from last decade’s boom. As they observe: “Most investors want to wait for a classic emerging markets crisis—a cathartic, correlated collapse—before committing capital.” But as they stay on the sidelines, viewing the entire sector as a monolith, this group misses opportunities to play reform in places such as Greece (now an emerging market and the world’s best-performing market in 2014) and Indonesia (the world’s second best-performing market). Missed opportunity begets pain, too.
Pain Trade No. 5: Policy mistakes crush the banks
Hartnett and his team note that in the February Fund Manager Survey, banks were far and away the biggest long relative to positions over the past decade. “Banks,” they write, “are the barometer of The Great Rotation. Gold is the barometer of The New Normal. Investors do not appear positioned for policy mistakes.” While the global economy is improving, nominal GDP growth remains historically very weak. Inflation is weak, and unemployment and debt are high. The pain? “If tapering in the U.S. and anti-speculation tightening in China retards global growth or increases deflation, we believe both longs in banks and shorts in gold will be disappointed.”