Last week, Bank of America presented 4 reasons why it finally threw in the towel on its long-held bullish small-cap trade reco, among which valuations, growth and confidence, credit and volatility. Today, JPMorgan's equity strategist Mislav Matejka similarly called for a near-term top in the market, saying key positive catalysts for equities are over for now, and recommended investors use any further near-term strength as opportunity to cut exposure to stocks.
Specifically, the JPM equity team notes that while "the big picture supports for stocks remain in place" the banks warns that "the near-term risk-reward might be getting less exciting. Some of the positive catalysts we have been looking for, such as a robust earnings season and the easing in political tail risks, have delivered and are now behind us."
At the same time, JPM warns that the six red flags have emerged for future risk upside:
- As demonstrated yesterday, the Citigroup's economic surprise index has entered negative territory. CESI has a good correlation with the S&P500 and points to 10%+ downside for stocks – see page 9. US loan growth is weaker. Eurozone M1, an important lead indicator, points to lower PMIs, as well. Additionally, China new project starts have collapsed.
- Sentiment is getting complacent, with SX5E in overbought territory and VIX back to record lows. Cyclicals vs Defensives are now overbought, as are Banks.
- Summer seasonals are negative. In the past 40 years, equities tended to post their best returns in April, but May onwards would see the worst returns.
- Bond yields bounced recently, but are struggling to break out of their ytd range.
- Commodity prices are weaker, specifically iron ore and Brent. This is a problem for reflation trade => inflation prints could roll over meaningfully, as could Chinese PPI, which has implications for Chinese corporate profitability – see charts on page 17. Inflation forwards are back to November levels.
- Italian political concerns could retake centre stage earlier than consensus assumes
JPM's conclusion: while in the very short term equities will still benefit from continued capitulation and chasing, especially with Inflows into Europe clearly coming back (around 20-40% of past outflows have reversed so far, and there could be more to go) the bank says that "we look to use any further strength over the next weeks as a good opportunity to reduce exposure and lock in some profits."
Here are the details behind each "red flag"
Risk-reward is worsening, some red flags are appearing – 1) US The Citigroup Economic Surprise Index (CESI) has rolled over sharply
- The Citigroup Economic Surprise Index rolled over sharply recently and is now in negative territory. We note that the weakness was partly due to the CPI miss last month, which could be a one-off, but most recently the US manufacturing datapoints have weakened, as well.
- If the strong correlation between S&P500 and CESI holds, stocks could see almost 10%+ downside.
…CESI turning below zero is typically followed by softer returns…
- Market performance and sectoral leadership did not tend to weaken post the peak in CESI.
- However, past instances of CESI moving below zero are typically followed by weaker market returns and Cyclicals’ underperformance.
…equites typically perform strongly after ISM moves above 56 – this has played out to script, and ISM has now rolled over
- We found that the S&P500 has continued to move higher 100% of the time after the ISM composite moved above 56, such as it did in December. The last three months’ returns are in line with those
that were observed on past occasions.
- The typical strong equity move might have played out, and ISM has likely peaked.
US loan growth has rolled over, too; Eurozone M1 is pointing to softer Euro PMIs, impact of Chinese stimulus is waning
- US PMIs have rolled over most recently, albeit from relatively elevated levels. US loan growth is softening as well, which is a concern.
- Eurozone PMIs are at multi-year highs at present. However, M1 growth, which was typically a good leading indicator of PMIs, is pointing to some weakness.
- We also note that the impact of the Chinese stimulus is fading. This is seen in the sharp decline in new project starts
* * *
Sentiment might be getting complacent
Following the recent bounce, SX5E RSI has moved into overbought territory. VIX has fallen and is now back to the bottom of the range. Cyclicals and Banks are looking overbought vs Defensives
* * *
Seasonals are turning negative… April was typically the best month in Europe, but from May onwards the returns tended to be poor
Summer seasonality was typically negative.
Equities posted below average / negative returns on most occasion during the May-Sept period.
On the flipside, Jan-Apr and Oct-Dec produced strong gains, on average.
* * *
Bond yields need to break out of their range to drive next leg higher
- Bond yields have rebounded most recently, but they are failing to break out of the ytd range.
- Bond yields remain strongly positively correlated to the Value/Growth preference and to the Cyclicals vs Defensives performance.
- Yields need to move higher for the risk-on trade to continue.
* * *
Commodity prices are weaker, which hurts the reflation trade…inflation forwards have rolled over... Chinese PPI is likely peaking, which might put renewed pressure on Chinese corporate profitability
- Commodity prices have rolled over recently, particularly oil and iron ore.
- The positive base effects that drove the rebound in headline CPI are starting to fade.
- Break-even rates are stalling. They are back to their level of last November in the US
- Courtesy of the past bounce in commodity prices, Chinese PPI rebounded strongly, which in turn, helped the recovery in earnings.
- The recent rollover in commodity prices could put renewed pressure on Chinese earnings.
Commodity price direction is important for global earnings, both through top line and through pricing channels
- Higher commodity prices have fed into better corporate top-line growth.
- More broadly, there was historically a strong positive correlation between PPI trends and global earnings.
- The historical correlation between S&P500 revenues and oil prices is very strong.
- The recent weakness in commodity prices could thus be a problem for earnings into H2.
* * *
Politics could stay messy, despite the near-term relief in France…
- Macron winning the French Presidency on Sunday would remove a significant tail risk for the market.
- However, politics could remain a source of uncertainty. In the US, Trump has passed his 100th day in office with the lowest approval rating of any president since 1945
…Italy could be the next curveball
- Italy could lead to a risk-off behaviour if elections are held sooner that expected. Five Star Movement’s support remains elevated.
- Italy has one of the lowest approvals for the Euro, out of the main European countries.
- The political landscape has been gradually moving away from the centre in periphery. Non-mainstream parties have gained support over the last few years. This might stay the case.
* * *
We look to use any additional strength over the next weeks as a good opportunity to lock in some profits… watching flows is important for timing
- Europe has seen significant outflows over the past year. We think 20-40% of these outflows have reversed already. Over the next few weeks, there might be further capitulation by
bears, driving more inflows and further P/E expansion.
- We would use potential additional strength as a good opportunity to reduce exposure.