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A 'meaningful' market correction is close, says widely followed strategist

  • Bank of America Merrill Lynch chief investment strategist Michael Hartnett said the market could be heading to a significant correction this fall.
  • Hartnett said his firm's Bull and Bear indicator is close to a euphoric level that would trigger a sell signal, but he said it's not time to move out of risk assets just yet.
  • The strategist says it won't be "your average correction. It's going to be something a little more meaningful."

Widely followed strategist Michael Hartnett can imagine pushing the sell button sometime soon.

"I personally think there's still some more upside, but I think there will be a moment and quite a significant moment, probably in October or November, but it could be September, when the markets are going to correct and correct quite meaningfully," said Hartnett, Bank of America Merrill Lynch's chief investment strategist.

Hartnett said his call for an "Icarus"-like runup in stocks this year and then a letdown appears ready to play out, based on action in his firm's Bull and Bear sentiment indicator. The indicator has crept to 7.6, close to the euphoric level of 8 [out of 10], that triggers a sell signal for risk assets. The indicator hit the sell signal 11 times since 2002, and it last signaled 'buy' when it went to zero in February 2016, the end of the last correction of more than 10 percent in the S&P 500.

Like the mythological figure Icarus, the S&P could fly too high and get scorched, if Hartnett's forecast plays out.

"It won't be your average correction. It's going to be something a little more meaningful. It will depend on a lot of factors," he said. Hartnett also said he does not see the end of the bull market, as a new bear market would not begin without a recession or some other major event. BofA's U.S. equities team has a target of 2,450 for year-end for the S&P 500, just below current levels.

"The call is it's a lot of risk assets will get caught up," said Hartnett. "High yield, emerging market debt and equities, those would be the three asset classes that would be most likely to come under pressure," Hartnett said.

As for U.S. stocks, since February 2016, there have been two shallow pullbacks in the S&P —around 5 percent before last November's election and about 6 percent around the June 2016 Brexit vote.

Hartnett said he doesn't have a specific target on the correction yet, but he feels investors are becoming too complacent about the current move to daily highs lasting through the end of the year.

"I feel now just the dovishness of the ECB and Fed of late and perhaps the move in the dollar, perhaps the decent economic data … the pushback is people have gone back to Goldilocks rather than Humpty Dumpty. Nobody believes in our Icarus theory. Now the market's gone up, and people are thinking maybe the Goldilocks is going to hang around a bit," he said.

The strategist says he's not recommending a move out of risk assets yet but he's keeping an eye on the Bull and Bear indicator.

"The Bull and Bear is a pretty good, strong reliable positioning indicator. It's pretty close to as good as it gets, but we do need to see flows to high yield pickup. We do need to see flows into emerging markets, both equities and debt, continue to be strong. And another key indicator is the cash level, which you recall in the fund managers' survey has been coming down a little, but it needs to come down a little further," he said. The indicator has 18 components, including information on flows, positioning and technical indicators. It also uses data from BofA's monthly global fund managers' survey.

The indicator has 18 components, including information on flows, positioning and technical indicators. It also uses data from BofA's monthly global fund managers' survey.

Bull and Bear indicator

Hartnett said the signals to watch are peak positioning, peak profits and peak policy stimulus. Hartnett said the market correction would likely come with some event, like the peaking of the profit cycle or a change in QE or monetary policy. "This is why we're calling for Humpty Dumpty over the second half. We do think at some point in the second half, the peak positioning will become clear," he said.

The Fed is widely expected to announce that it is going to begin unwinding its balance sheet at its September meeting, and European Central Bank President Mario Draghi will be speaking at the Fed's annual Jackson Hole Symposium at the end of the month. Either of those is an opportunity for markets to suddenly pay attention to central banks.

Stocks have rallied in "defiance" of the Fed's promise to reduce its bond purchases, with the Dow hitting another new high Friday. But Hartnett believes September is too "obvious" a time for the correction and it's probably not coming until later in the autumn.

"The clincher will be the profit side, and that we have real evidence from PMIs, the macro versions, that they're rolling over as well. Then you could make a case that this run from 2016 [low] will be over," he said. Some strategists say corporate profits have peaked, after rising 15 percent in the first quarter, and so far more than 10 percent in the second quarter.

WATCH: Market top ahead, says BofA's Hartnett