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Bank of America warns a new bubble may be forming in the stock market — and shares a cheap strategy for protection that is 'significantly' more profitable than during the last 10 years

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  • The attractiveness of US assets relative to the rest of the world is brewing a bubble in the stock market, according to equity-derivatives strategists at Bank of America. 
  • They formulated a cheap strategy designed to profit from limited gains in some of the worst-performing stocks. 
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Stock-market rallies do not have to be as monumental as the dot-com boom in order to qualify as bubbles.
For equity-derivatives strategists at Bank of America, the forces lifting the market higher are powerful enough to potentially make stocks vastly overpriced. None of these catalysts is hard to dismiss — even for bearish investors who doubt that the economy will quickly recover from the coronavirus crisis in a V-shaped manner.
Most importantly, the US has provided more monetary and fiscal support than any other country during this downturn and made the appeal of its financial assets irresistible.
The concern shared by Bank of America is these gains could prompt investors to dust off a playbook that worked after the 2008 financial crisis: buying price dips and betting that weaknesses will be short-lived. Quant investors who are insensitive to price and willing to add more risk to their portfolios then join the buying, creating a marketwide fear of missing out that fuels the market higher. 
"A major risk therefore is the formation of a US equity bubble as fundamentals take a backseat to investors' need to allocate capital to what's arguably the safest risk asset left," said a team of strategists including Gonzalo Asis in a recent note.
The backdrop for this bubble scenario is the worst economic contraction since the Great Depression, which investors appear to be tossing to the back seat. But the strategists' study of every contraction since 1929 led to the conclusion that a a sustained rebound from the March low would be a historical anomaly.
And so, we're left with two competing risks. Investors who are skeptical that this time is different may need to capitulate and buy a market that just keeps flying higher. And on the other hand, stocks may simply be staging a classic bear-market rally that collapses.
Bank of America's recommendation is not to pick one of these sides. Instead, the strategists devised a strategy that would help investors hedge the bubble risk while participating in its upside. They view it as a cheap way to "rent" rather than own stocks that might rise.
The team's apparatus involves call spreads, designed to bet on limited price gains. It is executed by simultaneously buying and selling an equal number of call options.
The strategists screened for stocks in industries with the worst performance since the market peaked in February 19, as these have more upside room. Also, the chosen stocks have a historically flat call skew, meaning traders are not paying a premium to bet on price increases.
"Call spreads on Delta, Wells Fargo, United Airlines, MGM Resorts, and Aflac offer significantly higher payout ratios than typical over the past 10 years," Asis said.
SEE ALSO: Bill Miller and 5 longtime value investors share 10 stock picks they're betting on right now — and explain why these are the best companies for the crisis recovery
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