The early February stock market correction wiped $6 trillion off the global market capitalization before equities reclaimed a chunk of lost ground. But there are at least six reasons why markets may test those recent lows, according to analysts at Bank of America Merrill Lynch.
A $6 trillion drop in global market cap would imply a test of 2,534 for the S&P 500 SPX, +0.51% they said in a Thursday note. The benchmark index was little changed at 2,678 on Friday, bouncing back from an earlier decline inspired by trade jitters but on track for a 2.5% weekly decline.
The analysts cited positioning, profits, policy, protectionism, price action and pain as the reasons for investors to be cautious about.
Investors are still very bullish, judging by their equity positioning, they said.
BAML client allocation to equities is at 61%. Investors conditioned by years of success for the “buy the dip” strategy, poured $17.7bn into equities last week. Meanwhile, technology, financials and emerging market debt and equity fund remained as crowded as ever, they said.
BAML analysts indicated that profits of U.S. corporation have peaked, while consumer confidence and manufacturing activity are booming amid low unemployment rate.
The consumer confidence index surged in January, hitting the highest level since November 2000 at 130.8. The ISM manufacturing index hit 60.8, highest level since May 2004. Meanwhile, the unemployment rate at 4.1% stands at 17-year low.
BAML’s assertion that profits peaked come from their model, which is pointing to a rollover in earnings per share growth, contrary to the 12-month forward estimates of 20% (see chart below).
Monetary policy globally is reaching its turning point. Global central banks “have played ‘whatever it takes’ card, by year-end Fed will have hiked 9 times, fiscal card played aggressively…no more stimulus to discount,” the note said.
This week, Federal Reserve Chairman Jerome Powell and other policy makers hinted that four rate increases this year are not out of question if economy starts overheating.
Protectionism: Investors are finally paying attention to the dangers of trade-war rhetoric. President Trump’s announcement of tariffs on steel and aluminum imports sparked fears of full-blown trade wars. Equities sold off Thursday and early Friday before recovering some lost ground.
Read: Here’s why the Dow is taking the Trump tariffs so hard
Knowing how much Trump likes to tout the stock market’s performance, the analysts said a further drop in stocks “may be necessary to stop escalation of trade war.”
Price action in technology, credit spreads, home builders as well as relative performance of equities versus government bonds suggest further weakness, they said.
For example, tech stocks are not making new high and credit spreads are not making new lows, the opposite of which is usually viewed as bullish. Home builders are making new lows and global stocks are not outperforming global government bonds.
The final “P” is for pain: The turn away from subdued inflation, interest rates and volatility that had been driving the 9-year bull market in equities and corporate bond markets is “now challenging bullish consensus,” they wrote.
So what’s the bigger picture? The “topping process” has began, the analysts concluded.