The equity quantitative team at Bank of America Merrill Lynch thinks this complacent stock market, lulled to sleep by high expectations for growth and central bank stimulus, is “ripe for disappointment.” What does disappointment look like? Markets could fall by 8% before year end, as the bank lowered its price target on the S&P 500 to significantly lower levels than present.
After adding discretionary overlay, BAML says stocks could drop to 2,000 level by year end
Considering BAML’s S&P 500 target models that incorporate valuation, sentiment and technicals, the S&P 500 might be expected to find a year-end value of 2150 if this formula were devoid of additional input. The broad-based stock index closed today at 2,190, implying that it is ahead of the bank’s models.
But a value reduction of 40 points might not bring stocks back into value alignment, the report says. That might require a nearly 200-point dip in prices before a rebound takes place.
In deploying an apparent discretionary overlay on top of their price target modeling, bank researchers deliver the bad news. “We continue to incorporate a significant likelihood of another sizeable correction in the coming months,” the report said, pointing to a year-end target of 2000.
With volatility at near post-crisis lows, investors have fallen asleep amid not apparently being paid for risk. “A contentious election season and Brexit could weigh on already weak corporate confidence and spending, credit fundamentals remain weak and Fed hikes should come back into focus,” the report said.
Its not current earnings that matter, but the future
What has driven this unprecedented market rally in the face of risk? “The rally over the last six months was initially driven by an improvement in the growth outlook for which investors were not positioned.
In an investment world put to sleep by quantitative market measures, the August 15 report notes that “market returns can be healthy even without (earnings per share) growth.” What matters are the projections of future growth.
“In the four non-recessionary years of negative EPS growth since 1960, the market was up in all of those years,” the quant team reassured. In other words, what has been happening is investors don’t let silly earnings and corporate profits get in the way of a good rally. With corporate stock buybacks contributing 1% to 2% on a stock’s growth over the last seven years and higher forecasts of coming earnings, this bull market is going to keep going until it doesn’t.
From BAML’s quant perspective, the market might take a dip, but that could be a buying opportunity.