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BofA warns of volatility-shock risk due to market fragility

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Investors need to guard against violent price swings as markets become increasingly fragile, according to Bank of America Corp.

[NORTH CAROLINA] Investors need to guard against violent price swings as markets become increasingly fragile, according to Bank of America Corp.

Fragility has increased due to high-frequency traders shutting down machines as stress rises, which hurts liquidity, as well as by trend-chasing among investors reaching for better returns "against their better judgment in a world addicted to the central bank put," BofA strategists led by Nitin Saksena wrote in a note May 19.

That's also created "a massive log-jam for liquidity" when things go sour, as players with little conviction rush for the exits, they said.

"With most institutional investors believing this is a bear rally, but at risk of being forced to chase the trend if it continues (having been conditioned as such in the last 10 years), the risk is of bigger bubbles leading to larger shocks," the strategists wrote. "There will be plenty of opportunity (and time) for negative surprises to arise, given the sheer size of this economic crisis, even with a vaccine on fast-track."

Asset prices have certainly moved with speed as Covid-19 wreaked havoc on economies and markets worldwide. The S&P 500 suffered its quickest-ever downdraft from a record into a correction. And as markets recovered amid waves of central-bank pledges and fiscal measures, the rebound was quick, too. Both the Cboe Volatility Index, or VIX, and Europe's VStoxx have fallen near their fastest paces in history, BofA said.

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"History suggests markets won't escape economic reality, and that this bear market will be similar in length to that of the ensuing recession," BofA said.

One potential solution, according to BofA: A Russell 2000 versus S&P 500 June 2021/December 2021 forward variance spread. The trade could likely do well in either a prolonged recession or in a major catch-up rally by small caps, which have been underperforming their larger peers, the strategists said.

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