"We believe the air in risk assets is getting thinner and thinner, but the Big Top in price is still ahead of us," Michael Hartnett, chief investment strategist at BofAML, said in a report for clients. "We will downgrade risk aggressively once we see excess positioning, profits and policy."
Indicators that market positioning has gotten out of hand and signaling a fall would include active funds attracting more money than passive (there's a $476 billion gap this year in favor of passive), and portfolio allocation for equities exceeding 63 percent, a level currently at 61 percent.
Hartnett pointed out that the current bull will be the longest in history if it continues to Aug. 22, 2018, while the outperformance of stocks versus bonds, at seven years running, would be the longest streak since 1929.
The forecast is predicated on three core beliefs: The first is the aforementioned capitulation; the second an expectation of "peak positioning, profits and policy" that "will engender peak asset price returns" and a low in volatility; and, finally, an expectation that higher inflation and corporate debt along with tighter monetary policy will roil the corporate bond market, a critical prong of the risk asset rally.
"The game changer is wage inflation, which on our forecasts is likely to become more visible," said Hartnett, who projects that salaries could rise 3.5 percent and push the consumer price index up 2.5 percent and convince the Fed that it's close to meeting its 2 percent inflation goal.
However, that cuts both ways: Should wage inflation again fail to materialize, Hartnett said "the era of excess liquidity" continues, bond yields would fall and the Nasdaq tech barometer would go "exponential." That would signal a bubble that might not end until 2019, when a bear market would be triggered by "hostile Fed hiking, Occupy Silicon Valley and War on Inequality politics."
"Big Top" trades favor technology, homebuilders, Japanese banks and the dollar against the Swiss franc.
BofAML's forecast comes as Goldman Sachs released a price target of 2,850 for the S&P 500, after a comparatively bearish 2016 call for 2,400 that was passed six months ago.
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