Record-high stock prices are increasing the risk of 'fragility shocks' in the next few months, Bank of America says

• Record-high stock prices and calm markets are increasing the risk of fragility shocks, Bank of America said.
• The bank's analysts said they think investors are underpricing the risk of a change in Federal Reserve policy.
• However, the BofA analysts acknowledged that there is a strong "buy the dip" impulse among investors.

Record-high stock prices and a possible change in Federal Reserve policy have heightened the risk of "fragility shocks" hitting equities in the coming months, Bank of America analysts said.

Last week's sell-off on Tuesday and Wednesday was a sign that investor sentiment remains nervy and could be vulnerable to bigger shocks in the future, analysts including Riddhi Prasad and Benjamin Bowler said in a note on Tuesday.

Stocks have since rebounded to all-time highs, but the analysts said this "will merely encourage more of the investor behavior that historically precedes larger fragility shocks."

In a note last week, BofA analysts said investors had been drawn into low conviction, momentum-driven positions that could be unwound all at once into an illiquid market if the tide turns.

Read more: Stocks faltered in a worrying way this week. 3 of Wall Street's most renowned strategists unpack why they think things are about to get even uglier.

The bank's analysts said in their latest note they're particularly concerned about the potential risks surrounding a possible change in Federal Reserve policy, as the central bank debates when to start withdrawing support for the economy.

"We believe the US equity market is underpricing the risks of a looming tapering cycle. After all, the equity market has feasted on record monetary support post-COVID, and the Fed's outlook remains impaired by the extreme uncertainty in the macro forecasts on which they base their decisions."

The analysts did not spell out their exact definition of a fragility shock, but implied that it meant a relatively sharp drop in stock prices.

However, BofA acknowledged that last week's market sell-off had been met by investors rushing to "buy the dip" in stocks, pushing them back higher. The analysts said that "the jury is out on whether these mini-selloffs are just a feature of today's market or foreshocks preceding a larger fragility event."

The S&P 500, the benchmark US stock index, has risen more than 90% since hitting a pandemic low in March 2020. It has consistently hit record highs over the last few months.

In the note last week, BofA said Federal Reserve Chair Jerome Powell's speech at the virtual Jackson Hole meeting of central bankers on Friday could trigger stock market volatility. It also highlighted August US payrolls data, due on September 3, and the September 22 Fed meeting as potential catalysts.