Bank of America: "The Best Reason To Be Bearish Is...There Is No Reason To Be Bearish"

Back in mid-July, Bank of America chief investment strategist Michael Hartnett wrote "The Most Dangerous Moment For Markets Will Come In 3 Or 4 Months" in which he warned that "further upside in risk assets will create problems later in the year" and concluded that "ultimately, we believe the extremely strong performance by equities and bonds in H1 is very unlikely to be repeated in H2" because "monetary policy will have to tighten to raise volatility, reduce Wall St inflation, and reduce inequality. There are two ways to cure inequality: you can make the poor richer, or you can make the rich poorer. The Fed will reduce its balance sheet in the hope of making Wall St poorer."

Or maybe not, because almost three months later, the same Hartnett today writes that the "best reason to be bearish is...there is no reason to be bearish." and admits that the "Icarus 'long risk' trade extended into autumn (Humpty-Dumpty "great fall" postponed a tad longer) by low inflation, big liquidity ($2.0tn central bank buying), high EPS, and promise of US tax reform", noting that the "monster rally in credit and equity markets began 18 months ago when best reason to be bullish was there was no reason to be bullish."

And with the VIX approaching all time lows as the S&P hits another daily high, the BofA strategist reiterates that his "Icarus Rally" price targets for Q4 remains 2630 in the S&P, 6666 on the Nasdaq, and the 10-year Treasury hitting 2.85%, as the rising dollar pushed the EURUSD down to 1.15. So what will prompt Q4 peak in the market? According to the BofA strategist, the catalyst will be a "Q4 "top" driven by tax reform, i.e. "peak Policy, a rise in MOVE index, and a peak RMB.

As Hartnett details further, here are the three catalysts that could end the current period of record complacency.

  • Tax reform = "peak policy" = buy rumor, sell fact…but too early to sell fact; tax reform = quicker Fed balance sheet reduction and less share buybacks if capex accelerates (since 2009 lows S&P equity market cap up $15.3tn, Fed's balance sheet up $4.5tn, share buybacks up $3.5tn)
  • Big jump in the MOVE index of US Treasury market volatility (i.e. "bond shock") catalyst for cross-asset vol, but requires inflation to rise
  • China financial conditions have tightened & EM "carry-trade" unwind another source of cross-asset vol (Chart 3)…Chinese policy panic kickstarted this 18-month rally, and consensus now much more complacent on China

The question then is how long after said top drags the market lower before the Fed casually hint that QE4 may be just around the corner to keep the wealth effect alive in perpetuity.

Here are some other observations from Hartnett on the latest weekly fund flows:

  • Risk-off week of flows: $8.8bn into bonds, $2.2bn outflows from equities, $0.3bn into gold
  • Q3 rotation from US to rest of world: week of $7.5bn US equity outflows biggest in 14 weeks; $23bn US equity outflows in Q3 vs $41bn inflows to rest of world, continuing clear flow divergence YTD (Chart 1)
  • Q3 "yield-on" continues in fixed income: inflows to HY bonds (biggest in 10 weeks) & EM debt vs Treasury outflows reflects ongoing lust for yield; $68bn IG bond inflows in Q3 dominated all fixed income flows and IG continues to be the big "yield winner"
  • Stocks star in 2017: YTD annualized returns…stocks 24%, bonds 7%, commodities -2%, US dollar -11%
  • Our Q4 targets: S&P 2630, Nasdaq 6666, 10-year Treasury 2.85%, EUR 1.15
  • Our Q4 AA: long stocks, commodities, volatility, US$, short bonds; more bearish AA expected in 2018
  • Our Q4 trades: long US$ vs EM FX, long oil, long barbell of uber-growth (IBOTZ, DJECOM) & uber-value (BKX) = Icarus trade; further unwind of extended "long disruptor, short disrupted" trade likely (i.e. death of old Retail, Media, Autos, Advertising by Tech Disruptors - Chart 2); rotational outperformance of oil>credit, EAFE>EM, value/growth
  • And monster rally in credit and equity markets began 18 months ago when best reason to be bullish was there was no reason to be bullish
  • Returns since Feb'16 lows: EM equities 63%, Nasdaq 45%, S&P 42%, HY bonds 30% reflect core bull market leadership of scarce Growth, scarce Yield
  • Global stock market cap up a massive $18.5tn over period, an amount equivalent to the entire US GDP
  • 318 trading days since SPX -5%, the 4th-longest streak since 1928
  • So risk assets can rally further but we expect Q4 "top" in equities and credit driven by: a. pricing-in of US tax reform (= peak Policy), b. rise in MOVE index (= peak Positioning), c. rally in oil + trough in Chinese RMB + upgrades to global GDP (= peak Profits)
  • Tax reform = "peak policy" = buy rumor, sell fact…but too early to sell fact; tax reform = quicker Fed balance sheet reduction and less share buybacks if capex accelerates (since 2009 lows S&P equity market cap up $15.3tn, Fed's balance sheet up $4.5tn, share buybacks up $3.5tn)
  • Big jump in the MOVE index of US Treasury market volatility (i.e. "bond shock") catalyst for cross-asset vol, but requires inflation to rise
  • China financial conditions have tightened & EM "carry-trade" unwind another source of cross-asset vol (Chart 3)…Chinese policy panic kickstarted this 18-month rally, and consensus now much more complacent on China

Meanwhile, as Hartnett concludes, the pain for active managers continues, because in a week in which ETFs saw another inflow of $1.2 billion, mutual funds suffered their latest $3.3 billion outflows.