Here’s the ‘best reason to be bearish’ in the final quarter of 2017

Should U.S. investors stay or should they go? That’s been the burning question for investors over the past year or so, against the backdrop of a bull market that seems incapable of being derailed.

Strategists at Bank of America Merrill Lynch have laid out that dilemma in their weekly flow show, which shows investors have continued to rotate out of Wall Street stocks and head elsewhere. “The best reason to be bearish is…there is no reason to be bearish,” wrote investment strategists Michael Hartnett and Jared Woodward.

While they expect risk assets can rally further, they think the fourth quarter will usher in a pullback, partly driven by investors fully pricing in tax legislation. The analysts had previously warned that U.S. stocks faced a final “melt-up” before succumbing, in a scenario they dubbed the “Icarus trade.”

Bank of America is targeting 2,630 for the S&P 500 SPX, +0.37% in the fourth quarter—the index isn’t too far off that with a close of 2,510.06 on Thursday, making for a gain of 3.6% in the quarter, with Friday’s session still ahead. Their Nasdaq Composite target for the final quarter of the year, looks slightly more ambitious, 6,666 versus Thursday’s closing level of 6,453.45.

Not all investors have been content to sit on the fence and watch stocks keep rising. The bank’s “Flow Show” data for the week ended Sept. 27 showed investors moving $7.5 billion out of U.S. stocks—the biggest in 14 weeks. For the quarter, U.S. equity outflows totaled $23 billion versus $41 billion in inflows to the rest of the world.

But Hartnett said the great “Humpty Dumpty” fall they’ve been expecting for U.S. stocks has been postponed a bit by low inflation, big liquidity provided by central-bank buying, high earnings per share for companies and the promise of a U.S. tax overhaul.

President Donald Trump and top congressional Republicans on Wednesday proposed sharp cuts to tax rates on businesses and many individuals, which helped provide a tailwind for stocks, though some investors still aren’t banking on any quick action.

That fall won’t be postponed forever. Hartnett and his team noted some signs of a top that could be getting closer. First, the “monster rally in credit and equity markets began 18 months ago when the best reason to be bullish was there was no reason to be bullish,” they said.

Emerging-market equities are up 63% since the lows of February 2016, with the Nasdaq up 45%, the S&P 500 up 42% and high-yield bonds are up 30%. But they reflect a “core bull market leadership of scarce growth, scarce yield,” said the strategists.

Global stock market capitalization is up a “massive” $18.5 trillion since February 2016, which is equal to the entire U.S. gross domestic product. And it has been 318 days since the S&P 500 has had a pullback of 5%, the fourth longest streak of its kind since 1928.

As well, they expect the top to be ushered in by a rally in oil, a trough for the Chinese renminbi and upgrades to global economic growth.

Risk assets can rally further, said Hartnett and his colleague, but expect a fourth-quarter top for stocks and credit markets. That will be driven by investors pricing in a tax overhaul, and a rise in the Merrill Lynch Option Volatility Estimate (MOVE), which measures bond market sentiment, moving up as concerns grow that interest rates are headed higher.

Here’s the latest update on the bank’s Bull and Bear Indicator (B&B), which sits currently at 6.9. “But stay long risk assets until sentiment reaches euphoric territory of 8.0,” said the strategists.
Source: MarketWatch

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