Bank of America: This Is The Only Number That Matters For The Market

When it comes to his recent forecasting track record, BofA"s Michael Hartnett is - as of this moment - a force to be reckoned with. Exactly one month ago, the bank"s Chief Investment Strategist warned clients that the bank"s "Biggest sell signal in 5 years was just triggered" and warned of a correction as much as 12% in the coming 3 months. Just a few days later, he was proven right as the S&P tumbled 10% the very next week.

Fast forward to today, one day the Jerome Powell "hawk shock" which resulted in yet another broad market plunge, when in a note titled aptly "Throwing in the Powell"...

... Hartnett takes us back in time 2 years, and writes that the 2nd day of Yellen"s Humphrey-Hawkins testimony on Feb 11th 2016 marked the last great “entry point” into the credit & equity bull market.

At the time the meltdown in China/EM/oil/HY induced extremely bearish Positioning (the BofAML Bull & Bear Indicator was 0), tumbling global Profit estimates (-7% YoY), and a big Policy stimulus (Chinese/ECB credit easing)…all of which swiftly followed Yellen’s defense of the Fed’s decision not to resort to a Negative Interest Rate Policy in the winter of 2016.

And what an entry point it was: little more than two years later on the 1st day of incoming Fed Chair Powell’s testimony, global stock markets are up 58% (a remarkable $30 trillion in market cap), CCC-rated US high yield bonds 69%, bank stocks 68%, Emerging Market equities 81%, tech stocks 92%, oil prices 139%. Only two asset classes have been in bear markets since Feb’2016: the US dollar (-8%), and volatility (both the MOVE & VIX indices recently hit 50-year lows).

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However, this time around "Positioning, Profits, & Policy drivers are now the mirror image of Feb’16." Specifically, according to the BofA CIO, the Fed is signaling the “Powell put” has a much lower strike price, "and as the Fed accelerates and leads the end of the global QE era, the bullish consensus is likely to capitulate to a more defensive posture through 2018."

So what should traders worry about as the market starts digging to uncover what the Fed"s new - and reduced - Powell Put is?

Well, according to Hartnett, 2018 year-to-date global asset returns have thus far been more prosaic: stocks 3.3%, bonds 0.4%, US dollar -2.5%.

In the absence of a stock market bubble (which remains a big risk given a dormant $10tn of negatively-yielding debt that can be reallocated to equities), muted and more volatile returns seem likely this year.

Still, for now at least the general direction of risk assets remains higher. But for how much longer? The answer for traders - according to Hartnett - lies in the magic number which is.... 3

Between bullish Positioning, peaking Profits (in the absence of Productivity gains), & Policy tightening, the likely cocktail in coming months of:

• real GDP forecasts >3%,


• wage inflation >3%,


• 10-year Treasury yields >3%,


• and the S&P500 >3000

... will mark a big top in equity & credit prices, the BofA CIO predicts.

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Here"s how this endgame to the biggest asset bubble in history will play out according to Hartnett in terms of Positioning, Profits and Policy.

On Positioning

• Positioning is extremely bullish: the BofAML Bull & Bear Indicator is 8.1, in stark contrast to the “0” level of early-2016 (Chart 2).


• The Icarus trade of 2017 has fueled “greed”: BofAML GWIM private client equity allocations are close to all-time highs (61.3%), global equity funds saw $103bn of inflows in Jan, and tech, financials, Emerging Markets & Japan funds have all seen record inflows in recent months.


• And market structure concerns continue to grow: short equity volatility AUM ($66bn) + volatility-based & risk parity equity leverage ($200bn) + CTA AUM ($250bn) + risk premium/factor allocation ($300bn; link) = $816bn of “market structure” that could make the recent VIX ETF/ETN implosion a dress rehearsal for a major market correction if volatility becomes contagious next time (our equity derivatives team estimates that in the Feb"18 correction, quant funds had to unwind $200bn in 2 days).

On Policy

• The central bank “liquidity supernova”, the primary driver of credit & equity prices in the past 9 years, will peak in 2018; central bank purchases of $4tn in the past 2 years will shrink to $0.4tn in 2018; assets such as tech stocks & high yield bonds, which have been the biggest winners under QE.
  


• “Don"t Fear the Fed” has been central to the BTD (Buy-The-Dip), FOMO (Fear-Of-Missing-Out) & TINA (There Is No Alternative to stocks) trades of recent years; yet Powell signaled in his Humphrey-Hawkins testimony that US “headwinds” have turned into “tailwinds”. The Fed is signaling the “Powell put” has a much lower strike price and as the Fed accelerates and leads the end of the global QE era, the bullish consensus is likely to capitulate to a more defensive posture through 2018.


• And note the central bank establishment (see Borio’s recent Bank for International Settlements link) has started to make the case that low policy rates have created “zombie companies” (estimated to now represent more than 10% of all OECD nonfinancial firms), leading to a misallocation of resources and low productivity…i.e. the “central bank of central banks” is making a positive case for a regime shift to higher rates

On Profits

• Profits remain the last visible bull catalyst, and thus the biggest risk to consensus in 2018 is weaker growth & lower interest rates (few predict Treasury yields below 2.5% and S&P500 below 2500 by end-year).


• We believe EPS growth is very close to a peak. A reversion to the mean in US manufacturing business confidence (i.e. ISM back to 54), payrolls (NFP back to 150K), and Asian exports (proxy for global trade) implies US EPS growth falling from 20% YoY% to 8% through 2018 (Chart 3). And Asian exports are now weakening: growth peaked last September at 21%, while the Feb China export PMI was below 50 for 2nd consecutive month signaling China exports stalling and weaker CNY once again ahead of us.

The gloom and doom from Hartnett continues as the strategist then warns that "the magnitude and duration of the bull market makes stocks more vulnerable to the peaking 3Ps in 2018":

• S&P500 bull market became 2nd largest of all time on Friday Jan 26th (@ 2873).


• S&P500 bull market will become longest ever on August 22nd, 2018.


• Should equities outperform bonds for a 7th consecutive year in 2018 it would be the longest winning streak since 1928 (equities most certainly underperformed in 1929).

Put differently, BofA can see only two catalysts to make this the greatest bull market of all time (3498 on the S&P500):

• An unanticipated surge in productivity growth.


• A speculative bubble from a Great Rotation out of negatively yielding debt into stock markets.

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So what should traders watch to decide when it"s time to bail? Well, if three is the magic number for the market, the decision when to get out of it depends - appropriately - on three letters: ABC. Here"s why"

Volatility set to increase in coming weeks with macro, policy & political events: US ISM March 1st, Italy elections/German coalition vote 4th, ECB 8th, BoJ & US non-farm payroll 9th, Pennsylvania special congressional election 13th, FOMC 21st. Key to watch: “ABC”: Average Hourly Earnings, Bond Sensitives & Chips (the

semiconductors)…

• A for Average Hourly Earnings: further wage growth acceleration is negative for bonds & equities, deceleration is positive for bonds & equities; in Feb payroll data AHE>0.3% is thus negative, AHE
  
• B is for Bond Sensitives: assets hyper-sensitive to interest rates such as utilities (UTIL), REITs (BBREIT), homebuilders (XHB), preferred shares (PFF) need to rally to confirm “bond shock” is over; in addition corporate bond spreads remain the “glue” that holds the bull market together…fresh weakness would be negative for all risk assets (watch European High Yield bonds, HE00, where yields have backed up 75bps since Oct 30th).


• C is for “Chips” aka the semiconductors; if semiconductor (SMH) & tech stocks (XLK) cannot make new highs in the next week or two, particularly at a time of soaring consumer confidence, then market highs could be seen in for the next couple of months.

Finally, here is Hartnett"s pair trade as we enter a period of extreme volatility: "Our favorite 2018 long remains volatility, our favorite short is credit, and the last move up in stocks should be led by a tech-banks barbell."