Michael Hartnett, Bank of America Merrill Lynch’s chief investment strategies, is bullish risk assets based on the bank’s positioning, profits and policy analysis. As the stock market continues to climb in the face of political uncertainty, it is “not dangerously euphoric” yet, Hartnett muses. This situation has not played itself out yet, he concludes in a February 7 report titled “Are we there yet? No.”
Stocks look like they are headed towards a “melt-up”
Just over one week after writing his investment analysis, Hartnett could not have known the US President Donald Trump would be embroiled in a scandal over Michael Flynn, his former National Security Advisor. Hartnett might not have realized that European Central Bank President Mario Draghi expressed concern that reductions in bank regulations might endear the next financial crisis. What really matters is the crisis in his own backyard, however, as member states are considering leaving the union.
Markets seem to be comfortable with policy uncertainty around the world. Could this be why in a press conference Thursday Elliott Management’s Paul Singer, a previous Trump critic, was no on board with the program, a development Elliott later confirmed to CNBC.
It is in this environment that Hartnett and his team of Brian Leung and Jared Woodard think current conditions are ripe for a “10% melt-up” in stock prices.
Hartnett Fear & Greed indicators have room to run, but are approaching the end
To benchmark his optimism, Hartnett uses his “Fear & Greed” set of indicators that determines tactical market calls and help anticipate key inflection points in asset prices “particularly when extreme Positioning coincides with turns in Profits & Policy.”
The extremes Hartnett observes in the market are not extreme enough. The BAML Bull & Bear Indicator, the broadest measure of investor sentiment, is currently at a 6.1 reading on a scale of 10. While that is significantly off the 2.0 reading during Brexit and the anomaly 0.0 reading during the February 2016 stock market lows, it still is not above the 8.0 reading that indicates investors are too emotional to the upside.
Looking at institutional cash levels as a measure of fear and greed, it currently is a bullish 5.1% while the macro indicator, a momentum-based cash analysis, has been trending significantly higher over the past two months.
Looking at the “Global Breadth Rule,” there is a marked change. Whereas nearly 89% of equity markets were “oversold” leading up to the winter 2016 market crash, now 78% of markets are overbought, getting very close to over exuberant sentiment.
Looking at the firm’s Long / Short sovereign modeling, the mathematical calculations, apparently not considering upcoming populist elections in their if-then logic, are long France as well as Sweden and the UK but are short Brazil, Norway and Singapore based on “momentum, value and profits” emitting from the sovereign jurisdictions.
To develop its thesis, Hartnet and his team note foundational pillars of analysis:
1. Structural market changes are more important than ever. Flow and positioning data help identify the impact of new market entrants, newly active participants (e.g. risk parity and quantitative funds), and the increasing prevalence of cross-asset mandates
2. It’s better to be buying. Our research shows that measuring fear is easier than measuring greed, and that market tops tend to be a process, whereas market bottoms form quickly. As a result, “buy” conditions are often more visible than occasions to “sell short” in our view.
3, It’s okay to assume some normality. Measuring overbought and oversold conditions works best when markets behave in line with history. For example, our mean reverting Global Breadth Rule functions better for trading conditions within one standard deviation than with >2 deviation conditions, e.g. conditions associated with the global financial crisis.
For now, Hartnett and his team see the stock market continuing to plow ahead, but by most of its measures the runway is not unlimited in length.