Last Friday, just before the market imploded on the higher than expected hourly earnings print, we published a Bank of America note titled "Our Sell Signal Was Triggered On Jan 30, S&P 2686 Is Next" in which chief investment strategist Michael Hartnett explained why he was convinced that a drop as much as 12% was imminent in the coming 3 months. He pointed to a proprietary bank indicator that - when triggered - had correctly predicted a drop that averaged 12% over the coming weeks. As a result, he said that his immediate target for the S&P was 2686.
With the S&P trading 100 points below his target just one week later, and 300 points below where it was just last Friday, we can now say that this indicator has been accurate on 12 out of 12 occasions.
However, if that was troubling, what Hartnett said today was even more concerning: in his latest Flow Show released on the same day as the record outflow from equity funds was revealed...
... Hartnett writes that after 706 rate cuts, $12.1tn asset purchases by central banks, global interest rates @ lowest levels in 5000 years, "2018 marks end of era of maximum liquidity, maximum asset returns, minimal rates, minimal volatility, minimal spreads…end of era of Wall St inflation thanks to Main St deflation."
He also reiterates what we - and Moody's - said earlier, namely that 2018 is the year when the US deficit exceeds $1 trillion, something which is clearly not lost on the 10Y yield, and in turn is prompting selloffs across equities every time the 10Y yield approaches 3%.
Which brings us back full circle back to Hartnett key 2018 BofAML themes:
- big long = Volatility
- big short = Credit
- big top = Equities
- big rotation = Deflation to Inflation
- big risk = Equity Bubble
And with Hartnett's original correction warning is now in the history books, having been confirmed just days later, the BofA CIO warns that more of is coming, with "correction vulnerability" in 2018'Q1 high due to:
- "Amazonification" of Main St (low inflation)
- "Japanification" of Wall St (low rates)
- "Icarus trade" (melt-up in risk assets)
These three have all became euphorically priced, e.g. China tech sector on 9x book (vs China financials on 9x earnings), European HY bond yields < US Treasury yields; VIX & MOVE at 50-year lows; global equity market cap +$30 trillion since Feb 11th 2016 lows.
The result is unfolding before our eyes, with daily 3-4% moves in the market, and nobody having any clue when the selling will stop.
Hartnett, however, has a clue what may be coming next: the reflationary year 1966, when rising rates caused a 16% drop in the S&P:
Structurally investors should study 2018 = 1966 analog…start of secular rise in inflation & interest rates caused S&P500 -16% in 1966, "Nifty 50-small cap value barbell" worked well (Chart 6) until inflation surge in 1969 caused massive shift from equities & bonds into commodities & cash (Chart 7).
Once dust settles, BofA's CIO expects:
1. much greater differentiation in leadership of Tech;
2. rotation from Davos Man to Joe Six-Pack portfolio e.g. long RTY, short SOX;
3. leverage will no longer be in vogue.
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In practical terms, here is how the correction will play out in chronological terms:
Correction chronology: XBT…UTIL…GT5…VIX…JNK…EMD…SPX; last Feb dominoes to fall should be DXY, CNY, SOX & EEM.
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Hartnett also knows how the correction/crash will end: with central bank intervention, or as he puts it: "markets stop panicking when central banks start panicking"
late-cycle crash/correction in 1987, 1998, 2016 all arrested by policy actions; crucial to note Fed now hawkishly selling Treasuries (Chart 4) and rhetoric past few days shows Fed "buyer of vol" not "seller of vol" for 1st time since 1987
That said, two upcoming events could soften the Fed stance
- Jan CPI (Feb 14th) <0.3%mom;
- Humphrey-Hawkins (Feb' 28th) opportunity for Powell to signal old, cautious Fed back.
Hartnett has two more notable observations.
First, how to know if this is a correction or a bear market? Look at the buybacks.
best sign corporations do not see profit peak is resumption of strong corporate buybacks in coming weeks; profits key determinant as to whether this is a correction or a bear market.
Putting this all together, Hartnett's reco is simple: use 2540 on the S&P and a 3% 10Y yield as "entry points in coming weeks."