5 reasons the S&P 500 could slump for the rest of 2021 despite strong profit growth and economic optimism, according to Bank of America

• Although the economic recovery is underway, stock market returns may disappoint in 2021, BofA said.
• The firm sees sentiment rising to dangerously euphoric levels.
• Here are five reasons why investors should brace for flat stock gains in 2021.

US corporations have been issuing positive guidance on profits and economists continue to upgrade their GDP estimates as optimism on the economic recovery accelerates. But this isn't necessarily a good sign for the stock market, Bank of America said.

A team of BofA strategists recently raised their 2021 earnings estimate to $185, but maintained their expectations for relatively flat stock gains for this year. The firm has a year-end price target of 3800 for the S&P 500, a nearly 8% pullback from current levels.

Here are five reasons why investors should "curb their enthusiasm" and brace for flat returns from stocks in 2021, according to Bank of America.

1) Sentiment

Wall Street bullishness is rising to near-euphoric levels, as seen by BofA's contrarian sell-side indicator. Their indicator is less than a point away from indicating overextended optimism on Wall Street and flashing a sell signal.

2) Valuation

The current valuation of the S&P 500 indicates "paltry" returns over the next decade, said the strategists.

"Valuation is almost all that matters over the long-term," BofA said. "With the increase in valuations in April, this framework yields 10-yr price returns of just 2%/year (versus 5% in Nov., and 10% 10 years ago)."

3) Outsized Returns

The S&P 500 posted 12 month returns of over 54% through March 2021, which was the third highest 12-month return on record since 1936. It was also 2.3 standard deviations above average. BofA data shows that losses have historically occurred for the next 12 months when the S&P 500 makes a 2+ standard deviation move like this.

4) Overshoot in fair value

One of BofA's fair value models forecasts the S&P 500 to hit 3635 by year-end. "This is based on our 2022 cyclically-adjusted earnings forecast of $173 and our equity risk premium (ERP) forecast of 425bp by year-end (vs. 398bp today) as 2H shifts to concerns about peak earnings and peak stimulus," said the firm.

5) Elevated Risk Appetite

A contrarian signal that measures the return on investments given the risk an investor takes has dropped to dangerously low levels, BofA added. In the two most recent instances that equity risk premium dropped below 400 basis points, the S&P 500 posted 10% and 20% peak to trough declines.

Against this backdrop, the strategists recommend investors buy cyclical stocks, small-caps over large-caps, and stocks that hinge on strong GDP and an expansion in capital expenditures.