Back in mid-July, BofA's chief investment strategist Michael Hartnett predicted that the "most dangerous moment for market will come in 3 or 4 months." Well, we are now "between 3 and 4" months since that particular forecast was made, and the "most dangerous moment" we have experienced since, ironically, has been today's modest selloff on the 30 year anniversary of Black Monday. So looking back at his forecast, has Hartnett thrown in the towel on calls for a correction, and joined all the other BTFDers? Not quite: instead, Hartnett's thesis has merely shifted, and he now contends that having entered the market's melt up somewhat late, a bubble which as shown before has unleashed raging purchases of tech stocks and credit, especially junk bonds...
... he expects the upside S&P momentum to linger, bursting to 2,670 before finally getting swept under the bubble tide. When will this happen? "We believe sometime between Thanksgiving & Valentine’s Day," or between 1 and 4 months, so even as Hartnett keeps the long-end of his forecast horizon fixed, he continues to expect that the next major move lower may come as soon as 1 month from today.
So how does Hartnett get to this conclusion, and what specific triggers is he looking for to launch the selling? Before we get there, here is an explanation of why we are where we are right now, i.e., what is the consensus trade.
What is consensus?
The zeitgeist of Wall Street can be summarized as follows:
- Bullish credit and equities with “Goldilocks” macro conviction
- No fear of the Fed (or ECB, BoJ…), expectations for a “good” rise in bond yields
- Long positions in stocks, IG/HY/EM bonds, EAFE & EM equities, banks, a “sellers strike” in tech, shorts in commodities & government bonds…i.e. the death of mean reversion
Following his latest Fund Managers Survey (profiled here earlier this week), Hartnett notes that, obviously, "Clients are bullish risk assets".
This follows a massive rally since the lows of Feb 11th 2016, which has seen High Yield bond yields collapse from 10% to 5% in the US and from 6% to a record low 2% in Europe (Chart 2), the S&P500 soar from 1800 to 2550, likewise the Nasdaq from 4300 to 6600, China H-shares from 7500 to 11500, and the oil price double from $25/bbl to $50/bbl.
What prompted this massive move higher? Some say it was the Shanghai Accord, where DM and EM central banks sat down behind closed doors and agreed to halt what then was the worst global equity selloff since the financial crisis, and reflated risk assets. Hartnett has a different explanation:
Back in Feb 2016 the “3P's”, Positioning, Profits, Policy, conspired to create a massive buying opportunity of risk assets. The BofAML Bull & Bear Indicator was 0, the definition of “excess bearishness”. Global EPS was contracting 6% YoY in early-2016, and expectations of recession were growing. And then the Fed, ECB, BoJ, BoE and the PBoC all eased: since Feb 2016 G4 central banks have bought over $3tn of financial assets.
Fast forward to today, when in the past 18 months "the global stock market cap is up an epic $18.5tn (>GDP of the US), propelled by wary Positioning in stocks & credit, a strong Profit recovery and the aforementioned monetary (& some fiscal) Policy stimulus. With so many clients desperately in need of a correction (“active” to outperform “passive”, private clients to raise portfolio beta, bond investors to meet future liabilities, sell-side to raise volume & volatility) corrections have proved elusive (the S&P500 has not fallen by more than 5% in 332 trading days)."
However, as we observed just last week, the wary optimism of the past 18 months is morphing into a melt up: a "greater conviction in the bull case for both credit & equity markets." Furthermore, as the latest Fund Manager Survey, Macro expectations of “Goldilocks” (above trend growth, below trend inflation) are now consensus for the 1st time since March 2011.
As a result, long positions in stocks & credit are unambiguous: "Big outperformance of CCMP, BKX, SX5E, more recently NKY, RTY, TRAN all indicate a market leaning very cyclical, and even oil prices are beginning to catch-up. Meanwhile, investors remain stubbornly bearish bonds: the FMS shows just 3% of investors expect lower bond yields in 12 months"
And arguably the most consensus trade of all is “no fear of the Fed”. Investors simply do not believe that aggressive monetary policy tightening is imminent, making “fear of the Fed” a likely catalyst to hurt consensus. Table 1 shows market implied policy rates over the next 1 year & 3 years for the Fed (45bps & 72bps respectively), the BoJ (-1bps & 7 bps), ECB (-2bps & 41bps), and BoE (55bps & 78bps, despite the UK unemployment rate dropping today to its lowest level since 1975).
Meanwhile, in today’s poster child for overheating, Sweden, the market predicts just 38bps of tightening in the coming year and 125bps in the next 3 years. Note a starting Riksbank policy rate of -50bps (one the most extreme monetary policy settings in history), fiscal expansion in 2018 equivalent to 1% of GDP next year, Swedish business confidence at an all-time high, a doubling of Stockholm house prices in the past 10 years, and so on.
All of the above explains how and why the all out euphoria that was launched in February 2016 brought us to where we are: all time highs in the S&P, coupled with ubiquitous complacency, no fear of the Fed, and so forth. So what happens next, or, as Hartnett puts it...
How & when will the Icarus melt-up in risk assets end?
The answer: "Icarus will end with peak Positioning, Profits & Policy stimulus"
According to Bank of America, "we believe sometime between Thanksgiving & Valentine’s Day. We expect >10% correction (say from SPX 2670 toward 2400). Below we list 10 signals of peak Positioning, Profits & Policy stimulus."
Which brings us to Hartnett's "10 Triggers for a >10% correction", which in this environment of record vol-sellers, who would create an instant "selling-begets-more-selling" feedback loop, promptly mutating into a crash.
1. 8: sell when the BofAML Bull & Bear Indicator exceeds “sell signal” of 8; since 2001 there have been 11 BB "sell signals" and hit ratio = 11/11; median MSCI ACWI losses thereafter -5.9% (1-month), -8.5% (2-month), -12.0% (3-month); BB indicator currently 7.4.
2. 4.2%: sell if cash levels in BofAML Fund Managers Survey fall to 4.2% from 4.7% in the next 2-3 months; note the BofAML Oct FMS global equity net OW of +45% has historically coincided with a pause in the equity outperformance versus bonds & cash over next 3 months (Table 2).
3. 63%: sell when GWIM private client equity allocation exceeds 63% all-time high (currently 60.6%).
4. $5.4tn: sell when the equity leadership and market cap of US technology ($5.4tn = >MSCI Eurozone & MSCI Emerging Markets) questioned by revenue growth deceleration (revenue at FAANG+BAT stocks = 28% p.a. 2012-16; growth forecast 2017-19 to decelerate only marginally to 24%); sell when GWIM private client FAANG exposure exceeds its 12.9% weight in the S&P500 weighting (currently 9.9%); note US tech within 4% of highest level versus global equities ex-US since 1967.
5. 52: sell when the US ISM index drops sharply toward 52 (3-month moving average – currently 58.6); peak Profits would also be signaled by a jump in oil prices to $60/bbl, because oil is the last cyclical asset to rally; and of course peak Profits would be signaled by an inverted yield curve (as has been the case in 10 out of 10 occasions since 1952).
6. $15.3tr: sell as we approach March’18, the month of peak liquidity as measured by the BofAML forecasted level of G4 central bank balance sheets; it will peak at $15.3tr (it’s $14.6tr today, up 4X from $3.6tr in Jun'08); the YoY% growth has already peaked and is set to turn negative in Jan’19.
7. 200bps: sell when the 10-year spread between Italian & German government bonds rises back above 200bps (currently 165bps); same for Spain (currently 122bps); the ECB has arguably been the liquidity catalyst the past 18 months and a widening of peripheral spreads would indicate their spell over investors is fading.
8. 2018: sell when peak policy climaxes with US tax reform, a classic “buy the rumor, sell the fact” market moment; after tax reform there will be no more stimulus for investors to discount, only monetary tightening in 2018/19; and if tax reform engenders more capital spending that means less money for share buybacks ($3.5tn past 8 years).
9. 1994: sell when inflation threatens 3½% US wage growth & 2½% CPI, levels that will provoke volatility; note a “Goldilocks” bull market ended dramatically in March 1994 with a payroll print of 464K, aggressive Fed hikes (100bps in 3 months); a rout in bonds (Jan-Nov’94 yields jumped 200bps) & a 10% drop in SPX; bear market ended with defaults of Orange County & Mexico…coincided with bond yield highs.
10. 1987/1998: sell when a much sharper 1987/1998 correction is threatened by a “market structure” event, i.e. passive investors, risk parity & quant funds become forced sellers, while vol sellers become forced buyers; ETFs represent $4.25tn globally, 18% of total managed fund industry AUM ($23.4tn) and 70% of daily average global equity volume in 2017; AUM of quant hedge funds now $432bn (up $271bn since 2009), or 14% of hedge fund industry AUM.
Hartnett's conclusion is that assuming no recession, the most obvious catalyst to hurt today’s consensus & incite a big correction is a spike in wage & inflation data that brings back “fear of Fed”. In our view higher bond yields and higher bond market volatility are necessary to engender a major correction in equity & credit markets.
Which, ironically, is precisely the opposite of what Mnuchin said yesterday, when he warned that the lack of a tax reform would crash the market: since it is stimulative tax reform that is precisely the catalyst for higher inflation and a spike in wages, the biggest risk factor for stocks is that Trump ends up getting what he asked for, namely sharply lower taxes, and higher wages, which would force the Fed to drastically accelerate its monetary policy tightening and hike rates much faster. Which is precisely what both Dudley and Kaplan had in mind yesterday when they said that "Trump's Stimulus-Oriented Tax Reform "Could Harm Economy" and Is "Ill-Timed"...