The U.S. stock market is at a record high. And as we enter the fourth quarter of 2017 with each of the major U.S. averages up better than 10% for the year, some investors might be looking around for reasons to be cautious on the market.
To Michael Hartnett, a strategist at Bank of America Merrill Lynch, just asking this question provides its own answer. The “best reason to be bearish in Q4 is there is no reason to be bearish,” Hartnett wrote in a note to clients last week. The lack of fear in markets, in other words, is something to fear.
Hartnett notes that 18 months ago was the beginning of the most recent leg up in the post-crisis bull market we’ve seen in both the stock and bond markets. At the time, Hartnett argued that the best reason to be bullish is that there was no reason to be bullish. The U.S. economy looked sluggish — indeed, 2016 was the worst year for growth since 2011 — as did the global economy, while the corporate sector was enduring an earnings recession brought on by the rally in the dollar and the collapse in oil prices. And while few foresaw Brexit and President Donald Trump’s election win, financial markets used both events as catalysts to run higher and break what had been over a year of choppy trading.
Today, U.S. and global economic activity appear to be picking up, while the corporate earnings recession has become a thing of the past. All of this seems to be fueling only bullish investment arguments.
Two trades driving markets right now
Jan Loeys, a strategist at JP Morgan, outlined in a note to clients last week the two trades driving the market right now — the growth trade and the tax trade.
The tax trade is effectively the return of the “Trump trade” we chronicled last week and hinges on investor optimism related to the Trump administration successfully getting through significant tax cuts in the U.S.
The growth trade is about investor optimism for, and recognition of, improving global economic growth. And so in contrast to a tax trade where U.S. small cap stocks and the dollar are leaders, the growth trade is positive for emerging markets and is dollar negative.
Overall, both stories are still positive for markets as a whole.
“The difference between the Global Growth Trade and the US tax Trade is mostly about where we take most of our risk: in the US or spread across the world,” writes Loeys.
“Given our view of eventually only a very modest growth impact from US tax cuts, one should simply spread one’s risk globally, focusing most on where there is the best value and where growth numbers have the most momentum. To this analyst that remains EM.”
Expect a fourth quarter top
The view that there are basically only two options for markets right now, and both of them are good, is, however, precisely what has Hartnett looking more skeptically at the market.
“Risk assets can rally further,” Hartnett writes, “but we expect [a fourth quarter] ‘top’ in equities and credit.”
Hartnett sees recent tax reform proposals as “peak policy” for investors as actual tax cuts would, in his view, lead to a faster balance sheet run-off from the Fed and fewer share buybacks as capital investment is tax-advantaged under the White House’s most recent outline. This is negative for markets.
Additionally, Hartnett sees a rise in the MOVE index — essentially, the VIX for the bond market — as a sign of investors being positioned for a shock in Treasury markets while the recent rally in oil prices, a potential trough in the Chinese renminbi, and upgraded views of global economic growth set markets up for a “peak profits” mode that current pricing will have trouble justifying over time.
Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland
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