With the US stock market likely to continue its levitation today, it means that by close of trading, the S&P500 will be above 2,400, the same as Goldman's year end price target, and 100 points away from Bank of America's "euphoric blow off top" destination, which is also known as Michael Hartnett's Icarus Trade. In a note released overnight, Hartnett confirms that he is "sticking with our “Icarus Trade” targets: SPX 2500, GT30 3.5%, DXY 110, oil $70/b", even as he admits that the euphoria level in stocks is unprecedented:
- Yes, markets are increasingly overbought (it’s now 96 trading days since SPX fell >1% in one session).
- Yes, sentiment is increasingly bullish (our Bull & Bear Indicator is 7.0, close to the 8.0 sell-signal).
- Yes, the easy money has been made. But we believe a March Fed rate hike at a time of booming macro data will cause the bears to fully capitulate into risk assets, causing the melt-up toward our targets in Q2.
He also notes that the renewed jump in bond yields is coinciding with renewed outperformance by small cap & banks, and by high yield bonds vs. investment grade bonds, "thus we are willing to remain long risk assets for a little longer."
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However it is what happens after this blow off top phase that is more interesting: that is the moment the "Icarus" trade becomes the "Humpty Dumpty" trade.
According to bank of America, "the “great fall” in risk assets comes when hawkish Fed & weaker EPS combine." That particular fusion will take place in H2, which is when Harnett says it will be time to get out...
The Fed has hiked just 2 times in the past 10 years. On March 15th the Fed will likely tighten for the 2nd time in 3 months. A second rate hike in 3 months would cause markets to anticipate a hike each quarter in 2017, and a jump in the Fed funds rate to 1.5-2% by early 2018.
As if that wasn't enough, March 15th is also the date of the Dutch election, and also when the US debt ceiling will be - hopefully - reinstated and immediately surpassed.
However, it is the Fed's tightening that is the biggest concern to BofA: "this acceleration of US financial tightening is a huge deal, and could in time become hugely negative. (In contrast, there were 35 Fed rate hikes in the 1970s, 28 in the 1980s, 11 in the 1990s, 20 in the 2000s – Table 1)."
Historically, once the Fed starts tightening, it keeps tightening until there is a “financial event” (Chart 4). This is likely to occur at a much lower rate of interest in the past given the economy & market’s reliance on QE in recent years,
Another warning from an increasingly concerned Hartnett: extreme US rate differentials can cause financial instability. US-German 2-year rate differentials are currently at 28-year highs (Chart 5). Rate differentials this wide have in the past either required either policy intervention (Plaza Accord in 1985) or have coincided with bad “events” (1987 crash, 1997 Asia crisis).
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Putting it all together, BofA writes that "while for the moment we remain tactically bullish, we need to acknowledge the vulnerability of risk once the Fed gets going raising rates, to the extent that they coincide with a bear flattening of the yield curve and lower EPS expectations (see Investment Clock above). Like Humpty-Dumpty, risk assets will invariably have a great fall once the “wall of worry” is climbed and investors stop worrying.:
After all:
- The current US equity bull market is already the 2nd longest ever, and will become the longest ever if it runs past August 22nd 2018; and the bull market will become the 3rd largest ever at 2467 on the S&P500.
- At some stage in coming months our Bull & Bear Indicator will likely exceed the “greed” threshold of 8 (Chart 6)
- Private client exposure to stocks will likely reach new all-time highs (current equity allocation is 60%, not far from Mar’15 peak of 63% - Chart 7); note their exposure to debt has already fallen to 12-year lows
- Meanwhile, with US consumer confidence at 15-year highs, small business optimism at 12-year highs, US ISM at a very high 58, and European PMI’s at 6-year highs, the run of better-than-expected data may end by this summer.
- And ominously, Chinese money supply (M1) growth – a lead indicator of Chinese nominal activity - has rolled over hard on a year-on-year basis (Chart 8)…and some might rightly argue that China (more than Trump, Yellen and so on) has been the true driver of the cyclicals in the past 2 years.
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BofA's bottom line: "we recommend buying S&P 500 puts for the second half of 2017."