Bank of America details red flags to watch for when hunting down cheap stocks

• Bank of America recommends value stocks over growth names as major indexes breach record highs, but warns that value traps could damage investors' portfolios.
• Value traps are stocks that seem inexpensive but are more likely to continue falling than stage a comeback.
• Bank of America searched for stocks with relative prices falling faster than their earnings, and found that real estate investment trust, telecom, and multi-utilities stocks screen as value traps.
• Investors should pick high-quality names with strong price momentum and fundamentals within the value space, the bank's analysts said.
• Visit the Business Insider homepage for more stories.

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Bank of America's analysts prefer holding value stocks over more expensive growth names, but see a handful of traps dotting the investing landscape.

Several gauges used by the bank identify the stock market as extraordinarily expensive. For one, the S&P 500 sits at record highs roughly five months after bottoming out on virus fears, despite the pandemic's economic damage still looming.

Stretched valuations across the market's darlings leave the best opportunities in value picks, the team led by Savita Subramanian said in a Tuesday note. However, certain inexpensive stocks pose a major threat to investors and should be avoided at current levels, they added.

The bank screened for companies and sectors that are inexpensive because relative prices are declining faster than their earnings. Though such stocks may seem like appealing buys at first, the analysts warn that their earnings deterioration can continue and leave investors with a rapidly depreciating asset.

Some sectors are fraught with traps specifically due to possible de-rating on pandemic-related risks, the team said, including real estate investment trusts.

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Advice for investing at record highs, including a 7-part stock-picking model

The stock market is sitting at record highs. So why does it feel like the party's already dispersing?

It could be the recent measured skepticism from firms like Morgan Stanley. While chief US equity strategist Mike Wilson isn't ready to predict another bear market, he did recently say that three conditions in particular could combine to spur a near-term correction.

[caption id="" align="aligncenter" width="400"]Photo by Got Credit [/caption]

JPMorgan has also joined in the lukewarm chorus, with strategist John Normand recently outlining what could trigger a bond-market sell-off that could threaten stocks. The implications of such a shift would bleed into everything from equities to gold — a situation that has Normand urging traders to hedge.

Also within JPMorgan is Eduardo Lecubarri — the firm's global head of small and mid-cap equity strategy — who predicts a rangebound stock market for the next year. But while his market-wide forecast is largely neutral, Lecubarri still sees select investing opportunities. He recently laid out 11 regions and sectors poised to outperform.

The Investing team at Business Insider is closely monitoring these shifting views to help you figure out how to excel in any market environment.

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She thought unemployment benefits were coming. Two months later, eviction loomed

Jennifer Moon has waited more than two months for unemployment benefits — and the delay presented a scary situation.

Absent any income, the 46-year-old, who lives in Cedartown, Georgia, fell behind on bills.

Lenders repossessed her car. She lost water at her home, which she rents, before a friend helped pay the bill.

Most significantly, Moon, a certified nursing assistant, also couldn't pay her rent. She missed two months of payments — $900 total — and next month's rent is due soon.

The landlord threatened eviction if Moon can't pay up by month's end.

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"I begged and pleaded with them," she said. "[They said] I have exactly 10 days to be vacated."

Making up the shortfall by returning to work is also a risky proposition

. Moon has a lung disease, pulmonary emphysema, which requires her to use oxygen and puts her in a high-risk category for Covid-19.

Moon, a single woman, doesn't have family to fall back on for help, and cares for a 30-year-old son with a disability.

Photo by malias

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Financial Derivatives Market

Markets for financial derivatives are booming

Collateralized loan obligations, or CLO funds, hold pools of leveraged loans made to businesses that qualify for speculative-grade or “junk” ratings. They have garnered scrutiny in recent years as the main buyers of leverage loans, which topped $1 trillion for the first time in history in 2018.

It is not a wholesale “indictment of the CLO market writ large,” wrote the report’s author, Elen Callahan, SFA’s head of research, who underscored that leveraged loans remain a vital form of credit for U.S. businesses and stressed that, unlike subprime mortgage CDOs of the past, no Triple-A rates CLO securities have defaulted to date.

“Today’s CLOs lack the synthetic exposure” and “re-securitization” of mostly subordinate subprime mortgage bonds, which Callahan also pointed out made prior CDOs “more susceptible to catastrophic loss,” after millions of homeowners defaulted of their home loans.

But several factors could pose unique risks to the CLO industry, including the end of the scandal-plagued London Inter-bank Offer Rate, which serves as the risk-free benchmark for most leveraged loans. Regulators plan to discontinue Libor in 2021 and the report points out it could “get messy for legacy CLOs.” Read more...

Contracts for difference (CFDs) are a form of financial derivative. Other forms of financial derivatives include futures, options and warrants. A financial derivative is a financial instrument that is taken from a physical asset such as a stock, bond or currency. There is then an arrangement or contract taken out against that asset between two parties with an agreement to that one party pays the other the difference of the value in the contract.
Contracts for difference are a contract taken out between two different parties, to pay the difference in the price of an asset from point of purchase to point of sale. The difference between the price of the asset will be determined by movements in the market.
Contracts for difference are unique as a financial derivative as they can be taken out on any type of asset. This includes stocks, bonds, currencies, indices, commodities, energy, property etc... All you are doing is creating a contract between two parties to pay the difference in the price from point of purchase to point of sale.
Contracts for difference can be created in both long and short positions. A long position is a position where the purchaser thinks that the price will go up. If the price goes up from the point of purchase, the person who sold the contract will have to pay the buyer the difference in the value of the contract. The value of the contract is reflected directly by the value of the asset. If the value of the asset goes down, the person who bought they contract would have to pay the seller the difference in the value. A short position works the opposite where the person who bought the contract would have to pay if the price goes up and the seller would have to pay if the price goes down.
Contracts for difference are usually traded on closed exchange, with a key entity acting as the market maker. The market maker is the individual or corporation who acts on the other end of the purchase. So you are always buying from or selling to a single entity. They make their money by profiting off incorrect trades, by charging a commission and by creating a spread on the price of the CFD. The spread represents the difference between the buy price and sell price of the CFD. Market makers also make money by charging interest.
Contracts for difference are usually purchased on margins. What this means is that if you buy $100 worth of contracts, you will only pay $5 in cash, and borrow $95 from the market maker. The market maker will then charge you interest on long positions and pay you interest on short positions. This is a similar concept to a margin trade in the stock market.
The benefit of having a margin is that you can take out much larger positions that you normally would be able to do as you only need 5% (or whatever the limit the market maker set) of the actual value of the purchase value to create the contract. The downside of this is that it is very easy to lose money quickly if the trade goes the wrong way.

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How to Trade With Implied Volatility

Last decade saw an implosion of volatility-related products,

Among the myriad Wall Street legacies of the soon-ending 2010s has been the emergence of market volatility - or the magnitude of security price swings over short time spans - as an asset class unto itself. It is all the more notable against the backdrop of the decade's fairly persistent market calm.

With the launch of these ETPs, trading in volatility was no longer limited to the futures and options market, where it all began. Investors could finally place bets on volatility as easily as trading stocks.

Investors plowed billions of dollars into both long and short volatility ETPs, with assets of select leveraged and inverse volatility ETPs hitting about $4 billion by the end of 2017. Assets in top volatility-linked ETPs now stand at about $3 billion.

Volatility selling became such a rage that analysts warned that the trade was creating a feedback loop where the more investors sold volatility the lower it slipped. Read more...

A broad term used with many financial instruments, each trader has their own style of volatility trading. In the institutional or hedge fund world, volatility is used as a measure of calculation to determine significant arbitrage opportunities. Commonly used with Exchange Traded Options and Shares, this strategy focuses on keeping a neutral risk position (ie delta neutral) and waiting for a change or mispricing in the option value to make a profit. The windows of opportunities are very narrow and require substantial bank roll to profit from such an approach.
The most common form of volatility trading can be adapted to all financial instruments. This style of trading focuses on pricing the volatility at a historical point to the relative or current volatility. Changes or spikes can indicate a number of possible factors including - economic, monetary policy, consumer sentiment, mispricing etc. Volatility traders will use this period to determine their position quantities and holding parameters.
The key question with volatility trading, is how to traders know when to execute an order. There are a number of technical tools which assist in the decision making process. These include:
VIX Technical Analysis
The VIX or Volatility Index has become significantly popular since the global financial crisis. Although it only tracks the option volatility of the S&P500, most traders highlight that this Chicago Board of Options Index is important in determining volatility levels. The significant weight of the S&P500 on the world markets is testament to this fact.
VIX is determined by the weighted average of options pricing in the S&P500. These spikes would only occur if there was significant volatility in the underlying stock. The chart below highlights the volatility levels in the VIX since 1990. As is apparent on the chart, the recent economic events, saw record levels of volatility come into the markets.
Chaikin Volatility: This is a less known technical indicator focusing on the differences between short and long term moving averages. The chaikin volatility indicator focuses on subtracting the longer term moving average from the short term accumulation / distribution moving average. Not a popular indicator due to its complexity, the chaikin volatility chart is quite useful when used in conjunction with the VIX chart.
Volatility is a key measure of market sentiment and can be used effectively as a trading strategy. A number of important factors to keep in mind when volatility trading include leverage (heightened forms of leverage during price swings can cause substantial losses and gains), and risk management (stop losses are extremely important during severe levels of volatility in the markets).

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How to Invest Using the Volatility Index

CBOE recently reported that the market volatility is at its low again,

All kidding aside, with about three weeks remaining, it’s been a fairly wonderful year for the S&P 500®. The large cap index is higher by about 25%. If the year ended today (12/6), this would be the best annual performance for the S&P 500® since 2013 (+29.6%) and the third best since 2000. The data below is through midday December 6.Source: S&P Dow Jones Indices More recently, S&P® 500 realized volatility (10- & 30-day) measured at more than two-year lows. One has to go back to October 2017 for realized volatility levels below where they were in mid-to-late November. There’s typically a relationship between historical and expected volatility in the broad market. As such, it’s not surprising that the VIX® Index measured 11.54 on November 26. That same day, 30-day HV in S&P® 500 dropped to 5.70%.

There are usually 252 trading days in a calendar year. Over the past decade, on average, there have been 52.8 moves of +/-1% (close over close) in the S&P® 500 per annum. Through December 6, there have been 38 in 2019. So over the past decade, on average, there’s a 1% S&P® 500 move roughly once every five trading days. Read more...

Looking at the market's performance over the past year, it makes sense that a great deal of investors feel the market rebounded too quickly. Many also believe that the market is set to correct after having recovered as aggressively as it did.
However, there is one way to examine whether the market's rebound was superficial or indeed worthy of continued growth and that is through the volatility index, or VIX as it is best known within the industry.

How To Use the VIX
Since volatility measures how much a trend will deviate from its norm, the volatility index expresses an amount of uncertainty among investors that the current trend or price movements will continue. This uncertainty makes sense because, as investors become less certain about a security or price, that number will shift wildly one way or another.
The VIX, therefore, tells us whether there is much doubt in the market. When prices are heading up and there is little uncertainty or doubt, then it is quite likely that the underlying upward trend will continue. If volatility is high as measured by the VIX, there is great risk that the trend will continue.

What the VIX Tells Us About Prices
When it comes to security prices, the VIX can indicate whether it is properly valued or improperly valued. When the VIX is high, the believe is that securities are not properly valued, but as that volatility reduces to a more-normal state, that price is more likely to "stick" or continue along its path.

Trading Based on the VIX
Many traders love making trades when the VIX is high. This is because prices will swing broadly from their "normal" range, allowing for greater opportunity for profit (and losses as well). However, when volatility is reduced, the indication is that the underlying trend will probably continue, meaning that returns (and losses) are a lot more predictable in the short-term when the VIX value is low. All it takes to make big money when the VIX is high (above 30-40) is to make the right call on the direction that the price will swing (up or down) and position your investment accordingly.

Evidently, the easier yet less lucrative method is to go with the flow (low VIX value) rather than make an educated gamble (high VIX value).
With the above in mind, the currently underlying trend is expected to continue. This means that the market's remarkable rebound during 2009 is not so much a quick, unjustifiable "bounce" as it is a recovery. And with the VIX values progressively getting lower, the indication is that the recovery period is really just getting started.

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What is Stock Volatility?

Volatility is a measure of the rate and magnitude of the change in the stock's value (up or down) of the underlying which is stated as a percentage over one-year. A higher volatility means there is more than average price changed during a trading day and a lower volatility means there is less than average change in the price of stock. When it is mathematically expressed, it is equal to the standard deviation price changes at the end of one-year period.
A stock having higher volatility is more likely that stock price change move towards deeper into the money. When volatility is high, premium of an option will be higher and vice versa. Traders would be benefited if they have good understanding of volatility. This helps them to estimate how an option is valued relating to the trends of the underlying stock.
A low volatile stock has good chance of price not moving at all. Thus, volatility is an indication which tells about the likelihood of the price of a stock going up or down. If you have purchased a call on a stock expecting to gain profit in the short run, you expect the price of stock to go up. This will give better chances of call becoming worthy in future. More the chances of call becoming worth in future, the premium on the option will be increasing. Keeping other things unchanged, it is good to sell an option whose implied volatility is high and buy if its implied volatility is low.
Volatility measures market expectations regarding how price of underlying asset is expected to trade in future. Implied volatility and historical volatility are the two types of volatility. Historical volatility is also known as statistical volatility. Using current price of an underlying asset as base, implied volatility reflects expected future volatility from the existing price to the price at the expiration. Where stock market perceives volatility for an option in the future is known as implied volatility. One can get the future value of implied option volatility for the future. One can also project the direction of the stock price using historical volatility and fair value of the stock along with implied volatility.
Historical volatility measures the stock's volatility based on how the underlying asset had been traded in the past. It refers to the past price movements of an underlying asset. Historical volatility helps in determining the possible magnitude future moves of underlying asset. It involves a statistical calculation and tells us how quick price movements are in a given time frame. This is the standard deviation which analyzes the range of data points against the average.
One can draw conclusion about the current and the future trends of option volatility by reviewing the historical volatility along with fundamental analysis. This is more important as one can calculate and expect the feasible prices changes of an underlying asset in the future.
Historical volatility shows how volatility has been in the past whereas implied volatility views expected future volatility based on current option prices. One can see the expected trading range of the market with historical volatility and implied volatility acts as an indicator of the current market sentiment.

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