- For months, Bank of America Merrill Lynch chief investment strategist Michael Hartnett has warned against stock market sentiment he thinks is far too extended.
- He’s identified six ways the stock market could see another correction rivaling the size of the one that transpired in early February.
Recovering from a stock market correction is only half the battle. Once a rebound gets underway, pessimists are already looking for reasons another one can transpire.
In this case, the skeptic is Bank of America Merrill Lynch chief investment strategist Michael Hartnett, who’s gone as far as to identify six possible drivers of another $6 trillion stock market selloff.
This bearish commentary should come as no surprise for followers of Hartnett’s work. For months he’s decried what he calls the Icarus trade, defined as a reversal of the “melt up” seen in stocks since early 2016. He also issued a strong sell signal right before the stock market’s recent 10% correction. He’s even gone as far as to outline a four-part formula for a market meltdown.
Put simply, Hartnett is no big fan of this rally — at least in its current form. For further proof of that, here are his six reasons the equity market could see another correction:
One of Hartnett’s main bearish arguments has long been what he describes in his most recent client note as “peaking optimism.” He views extreme investor confidence as a bad thing in the long run, because it makes traders blind to risks.
In order to track this, he maintains the BAML Bull & Bear Indicator, which provides a signal for market sentiment. While the gauge has fallen out of the “extreme bullish” territory that preceded the recent correction, Hartnett notes it’s still very high. He also cites the $17.7 billion that flowed back into equities after a massive exodus occurred during the selloff.
Here’s where the Bull & Bear gauge stands today:
Earnings growth has been the foremost driver of stock price appreciation throughout the nine-year bull market — but what happens if it slows down? That’s what has Hartnett worried. He warns profits have already started to peak, and says the eventual slowdown could sap equities of a trusted benefactor.
The chart below highlights Hartnett’s expectation of lower US earnings expansion:
Hartnett is specifically referring to monetary policy. He argues the “whatever it takes” ethos that’s been adopted by global central banks has to fade at some point, and notes stimulus is already drying up. That’s unfortunate for stock bulls, considering central bank accommodation has for years supplied a seemingly endless supply of fresh capital.
This is perhaps the most timely driver, considering President Donald Trump‘s recent announcement that he’ll seek huge tariffs on steel and aluminum, and his subsequent comment that “trade wars are good.” Hartnett warns “deflationary” behavior may be required to stop the escalation of a trade war — which would mean lower stock prices and lower yields.
5) Price action
For this section of Hartnett’s bearish playbook, he highlights a few stock market dynamics he finds anomalous, particularly compared to recent history. He notes tech stocks at large are failing to make new highs, while credit spreads aren’t hitting new lows, and homebuilders are.
Beyond that, Hartnett says global stocks are now underperforming global government bonds year-to-date, which he considers to be a troubling sign. The logic here is simple: If what got the stock market to near-record levels is no longer working, where is there to go but down?
The last section deals with three hot-button topics: inflation, rates, and volatility. Locked for years near historical lows, all three have started climbing, which Hartnett says has been “challenging bullish consensus.” And based on how new developments around each driver have put pressure on stocks in recent months, he would seem to have a point.
There is some good news
Had enough bearish content? Lucky for you, Hartnett has also identified two drivers that could prolong the bull market: (1) an unanticipated surge in productivity growth, and (2) a speculative bubble from a Great Rotation out of negatively yielding debt into stock markets.
While neither of these are part of Hartnett’s base case, they show he’s not sleeping on the prospect of a further stock rally, regardless of how unlikely he thinks it is.
And in a way, Hartnett’s wide speculation serves a microcosm for the stock market right now: no one truly knows where it’ll go next, so they’re considering all possible options.