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Why 'Wall Street excesses' pose 'greatest risk'

Call it the Derek Smalls Recovery, named after the Spinal Tap bass player in the famed mockumentary who strove to be "kind of like lukewarm water."

It's a time in which consumers and companies cut back on spending rather than make investments, where technology leaders fail to innovate and deflation and increased regulation become ever-larger threats.

It all adds up to "a world where Wall Street and the owners of capital boom while Main Street and the workers struggle," in the words of Bank of America Merrill Lynch chief investment strategist Michael Hartnett, who advised in a note to clients Friday that investors had better start thinking about market trouble for later in the year.

"The greatest risk of all is that Wall Street excesses rather than Main Street recovery forces the Fed to tighten," Hartnett said. "More than five years after the global financial crisis it's still a 'lukewarm' recovery. The 'fire' of zero interest rates and central bank liquidity continues to be doused by the 'ice' of deleveraging, regulation and deflationary tech innovation. Meanwhile Wall St booms."

Indeed, signs continue of an uneven recovery.

Christoph Wilhelm | Getty Images

For the first time in three years, nonfarm payrolls growth has topped 200,000 for four-straight months. Yet consumer confidence continues to meander, even dipping slightly in June as those in the lower income brackets feel pinched.

Read MoreConsumer sentiment in June unexpectedly slips

Economists are pushing hard on the belief that gross domestic product gains will improve dramatically for the rest of the year after the first-quarter's 1 percent drop—a number that Goldman Sachs on Thursday predicted would be revised to a -1.8 percent by the time all is said and done.

Hartnett pointed out that over the past five years, nominal GDP growth has been just 19 percent compared with the 45 percent that has been typical in recoveries.

Meanwhile, the stock market booms, with the S&P 500 up 190 percent off its March 2009 lows, thanks largely to easy Federal Reserve policy that remains vigorous even as it is in the process of unwinding.

Read MoreEconomists say the Fed is wrong about growth

"The longer it takes for growth and rates to normalize, the greater the risk of speculative excesses and ultimately a policy response aimed at curbing speculation in asset markets before the economy has fully healed," Hartnett said. "Eric Cantor's loss in a Virginia Republican congressional primary could be nuanced as the first U.S. electoral reaction against the elite, but the pitiful turnout of 12 percent suggests an electorate that holds out little hope that (Washington) can improve their economic lot."

In his note, he then makes another reference—to David Bowie's 1974 post-apocalyptic album "Diamond Dogs."

The firm has long been bullish the market, projecting a 2,000 mark for the S&P 500 in 2014 that would be eclipsed fairly easily if "diamond" current trends hold. At the same time, government bonds, emerging markets and gold—the expected "dogs" of the year—have rallied in tandem.

Read MoreWhy in the world do people keep buying Treasurys?

As things stand, Hartnett thinks the market will continue to rise through the summer but advises investors to "then belt-up" for the fall. He concludes:

The longer it takes for growth and rates to normalize, the greater the risk of speculative excesses and ultimately a policy response aimed at curbing speculation in asset markets before the economy has fully healed. We are a buyer of (volatility) into fall when correction risks rise significantly: either Q3 growth is +3% confirming recovery and cause rates to rise or speculative excesses appear causing central banks to start "talking down" asset prices. Until then be long but watch credit, the epicenter of the speculative fervor. One of the better leading indicators of the 1987 crash was a period of rising bond yields, rising gold prices and falling corporate bond prices.

—By CNBC's Jeff Cox.

  • Jeff Cox is finance editor for CNBC.com.

  • Lawrence Develingne

    Lawrence Delevingne is the ‘Big Money’ enterprise reporter for CNBC.com and NetNet.

  • Stephanie Landsman is one of the producers of "Fast Money."

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