Stocks and commodities could see a final 10 percent melt-up in the first half of the year, followed by a "meltdown" closer to 2018, according to Bank of America Merrill Lynch strategists.
"Call it the 'Icarus trade.' The current melt-up, which started back in February 2015, will be followed by a meltdown later in '17," writes the firm's chief investment strategist, Michael Hartnett, and other analysts. The strategists first see a "wobble" in January and February, but they don't expect a major first-quarter correction before the next surge higher.
"This is an eighth- or ninth-inning move. It can often be quite large and produce a big top," Hartnett said in an interview.
While the strategist is not quite calling for the death of the nearly 8-year-old bull market, he said, "It's getting long in the tooth. The thing about a melt-up is you get a lot of people chasing it."
Stocks could continue to rally before fizzling out in the second half of the year, closer to 2018, Hartnett said. He said one sign that "something nasty" is about to happen, would be if both the dollar and gold moved higher at the same time.
That's a rare occurrence, said Hartnett. "You see that there's trouble ahead. The warning signs would be credit, bank stocks [sell off]. Right now, there's nothing more contrarian out there than gold. That's not to say you buy it today. At some point, gold is going to move higher. It's going to start to worry about inflation," he said. When the market sees the withdraw of liquidity by the Fed or other central banks, that's when gold would rise with the dollar.
There could be some choppy periods in the meantime. BofA's year-end target for the is 2,300. It was just 30 points below that Monday.
Hartnett said in the near term, investors could also get anxious around the Fed's meetings Feb. 1 and March 15, especially since wage growth is beginning to pick up. Friday's December employment report showed the biggest average hourly wage gains since 2009, and continued strong jobs data and wage growth could signal a faster moving Fed.
"That's something that could make the risk assets pause for breath," he said.
Hartnett said the markets have already been factoring in the president-elect's promise of a corporate tax overhaul and infrastructure spending, and it's also showing up in some data and consumer and business activity. Trump's election also coincided with an already improving economy.
"The global economy was on an improving path before Trump was elected. The election of Trump has clearly stimulated animal spirits and expectations," he said.
Hartnett said he favors other markets over the U.S.
"The way we're positioned is for upside in Europe and the U.K. ... and Japan, relative to the United States of America, and emerging markets, and then in commodities a preference for oil, probably over others," he said.
The BofA strategists say the rally is likely to end with bullish positioning, "excessively bullish" profit outlooks and policy hawkishness. They said the markets have not quite gotten to the point where they will melt up. The positioning is not overly euphoric, though it is bullish.
The strategists also say the start of the Trump era has heralded in a change in investment themes from Wall Street to Main Street. They expect that to continue, with the emphasis away from globalization and winners being those that can thrive in a zero interest rate world, to a more isolationist theme and a world where there are winners from fiscal policy.
The themes that are now "in," include cyclical recovery, inflation and fiscal stimulus. "Out" are secular stagnation, deflation and fiscal austerity. Investments that are in include commodities, value, small cap, Japan, banks, real assets and active investing. Those that are out include bonds, growth, large cap, U.S., technology, financial assets and passive investing.
A core trade would be long banks, short bonds.
"The signals that the Big Top in risk assets is approaching in coming quarters will likely be fatigue in high yield & U.S. banks, a contrarian rally in gold, and rates volatility as the era of excess liquidity reverses," the strategists wrote.