David Gray/Reuters
- The stock market just had its worst week in about two years.
- After a euphoric surge, and amid several warning signals, some investors think the selling could continue, but won't be strong enough to derail the bull market.
- This week, strategists at firms from Bank of America Merrill Lynch to UBS advised clients to hedge against risk - just in case - but keep counting on economic growth to eventually lift stocks.
Investors found few places to hide this week, when the stock and bond markets experienced their biggest drops in a while.
Largely fueled by concerns about higher interest rates, the S&P 500 fell nearly 3% in its worst week since early 2016, while the rout in bonds spiked the 10-year yield to a four-year high.
Stocks are overvalued by many measures and compared to various historical averages. Sentiment is euphoric, according to some equity strategists. The risks of a correction are high, they warn.
The list of concerns goes on. But some investors aren't ready to throw in the towel.
On January 25, James Barty, an investment strategist at Bank of America Merrill Lynch, wrote in a prescient note on January 25: "while we remain bullish for the year as a whole this is beginning to look a little too frothy for our liking."
As stocks dropped last week - before the worst of Friday's sell-off, we should note - his clients challenged that view, even though the market appeared to prove his point.
"The pushback we received after our note last week was largely along the lines that fundamentals were still good so why should there be a pullback," Barty said in a note on February 2.
"We do not disagree with the solid fundamentals, which is why we have been bullishly positioned on equity markets for the last 18 months or so. It is just when many seem to agree and is quoting our own arguments back at us, we get a bit nervous."
Barty acknowledged that timing the market's top is hard, and recommended that investors hedge risk instead of unwinding long trades outright.
Meanwhile, he expects that earnings growth would continue to support the market.
Bank of America Merrill Lynch
"Our US strategists think that 50-60% of US tax reform is now baked into earnings," Barty said.
"The remainder will likely be there by the end of earnings season. This has had the effect of pushing the expected growth rate of MSCI ACWI earnings higher to above 12%. We believe that this is still achievable given the economic growth we are expecting."
'The bear still sleeps'
UBS' Chief Investment Office won't be found in the company of this market's bears.
The firm, which manages about $2 trillion in assets, remains overweight global stocks, with a preference for financials and technology.
"Even though a short-term market correction cannot be ruled out, we see little reason to believe that the next big market downturn is around the corner, for several reasons," said a team of strategists including Dirk Effenberger, in a note on Thursday.
"First, while equity valuations based on trailing price-to-earnings (P/E) ratios have been rising globally, no single equity market has alarmingly high valuations as of yet," he said. "Second, the synchronized global economic recovery is supportive of corporate earnings. Third, central bank policy remains accommodative for now. And fourth, we believe all of the risks we consider below have a low chance of materializing in the immediate future."
What could wake up the market bear, they warned, is if the Federal Reserve tightens faster than the market expects, and higher bond yields become a concern for debt refinancing.
'Almost certainly a buying opportunity'
For Citi's Global Macro Strategy team, a bullish shift in investor sentiment caused the recent pullback.
"Our basic point was that the market was massively overbought, had diverged hugely from its medium term bull trend and that sentiment had surged more bullishly across various constituents including retail and analysts, a point borne out by our anecdotal experience last week," said a team of strategists including Jeremy Hale.
Citi
Such spikes in sentiment aren't as worrisome when prior institutional flows into stocks are weak, Hale said.
The team plotted prior flows against forward returns and found that stocks were slightly positive when prior institutional buying was soft.
"We believe the current mini-correction is healthy in that regard and is almost certainly a buying opportunity eventually given sharply rising earnings that are likely to drive additional gains despite gradual removal of Central Bank accommodation," they concluded.