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Experts are calling for the 'Icarus' stock rally to finally lose altitude

Key Points
  • Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, has said the S&P 500 is "close" to a pullback, and will suffer a 10 percent correction "sometime between Thanksgiving and Valentine's Day"
  • Other expert market watchers said they expected U.S. equities will soon face a pullback
  • Some, however, say risks to the market's run have receded, and so there may still be meaningful upside ahead
An antique sculpture of Icarus from Greek mythology.
Sergey Vasilyev | Getty Images

The 2017 global stock market rally is showing signs of fatigue and a 10 percent correction in U.S. equities looks imminent, experts are predicting.

Conflict in the Korean Peninsula or a Middle East oil crisis are emerging as the main low-probability but potentially high-impact market events. A central bank policy error or the failure of President Donald Trump's tax plan are likelier catalysts that may break what Bank of America Merrill Lynch calls the "Icarus melt-up" in global equities led by U.S. stocks.

Though down for the second week in a row last week, the MSCI All Country World Index is on track for a record 13 months of unbroken gains. The and the Dow Jones industrial average notched up their seventh successive monthly win in October while the Nasdaq recorded its fourth straight monthly gain.

Many feel something has got to give.

"Icarus is flying ever closer to the sun," said Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, likening the seemingly inexorable rise in global stocks to the figure of Greek myth who tumbled from the sky after the sun melted the wax in his artificial wings.

Signs of potential trouble include U.S. equities valuations being stretched while margin debt — money borrowed by U.S. investors to fund share purchases — stand at record levels. Meanwhile, low volatility, the absence of sharp market moves, points to complacency about potential shocks that may upset the final stages of the bull market.

Thanksgiving and Valentine's Day

"Investors' risk-taking has hit an all-time high," Hartnett said in remarks accompanying the bank's monthly Global Fund Manager Survey released last week. "A record high percentage of investors say equities are overvalued yet cash levels are simultaneously falling, an indication of irrational exuberance."

The investment strategist warned that a spike in wages and inflation — forcing the U.S. Federal Reserve to hike rates faster than market expectations — could derail the Icarus rally.

"Investors simply do not believe that aggressive monetary policy tightening is imminent, making 'fear of the Fed' a likely catalyst to hurt consensus," Hartnett said in an October report.

The S&P 500 is "close" to a pullback, he said of the index that closed above 2,599 on Tuesday, forecasting it will hit 2,670 before suffering a 10 percent correction "sometime between Thanksgiving and Valentine's Day." That's a time frame coinciding with the Fed's closely watched December meeting, for which markets are widely expecting a third and final rate hike of 2017.

But those with a more positive market outlook argue that the chances are slim of an inflation overshoot radically changing the Fed's policy.

"An excessive move by the Fed could cause [a correction], but we're not there yet. When you look at the U.S. economy, it's growing at a modest pace and core PCE looks contained," said Neeraj Seth, head of Asian credit at asset manager BlackRock, referring to core personal consumption expenditures, a measure of inflation. "If there's a shift and there's a change in the rhetoric of the Fed, then that could be disruptive."

Passive aggressive

Global stocks may be underpinned by robust economic and corporate fundamentals, but warning signs are flashing upon closer inspection of the U.S. markets.

Some fear the rise of passive investing — buying a broad cross-section of a market using instruments like exchange traded funds (ETFs) — are causing distortions and raising the risk of a herd-like stampede when the trigger is pulled.

The "huge concentration" of ETFs represents "a clear and present danger to the markets," said Jim Mellon, chairman of asset manager Burnbrae Group. "I certainly wouldn't be buying the U.S. in the round at the moment and I would be thinking about shorting it."

Jason Ambrose, CEO of Singapore-based Vanda Securities, supported the Bank of America Merrill Lynch call for a 10 percent correction: "You're currently in a fight of strong momentum versus a potential central bank communication error — calling the end of that is hard."

Any market selloff could be aggravated by the build-up of passive index-tracking ETFs, Ambrose said, and newer investment instruments created by the asset management industry such as "risk parity" funds.

Those funds, which aim to spread risk equally across several different asset classes within a portfolio, have ballooned to $500 billion in assets in management, according to some estimates.

"There are days where systematic and passive flows account for more than 80 percent of SPX market turnover," Ambrose said, referring to the S&P 500's ticker symbol. "So importantly you have to know what they are doing, not what the 20 percent (active management) are doing."

Some believe a market tilted heavily toward those new products makes it inherently more susceptible to the type of negative feedback loop that characterized the "flash crash" of 2010.

"If there's a correction for any reason, it will be aggressive ... it will be dramatic and probably V-shaped," Ambrose said, explaining that the newer and increasingly dominant investment strategies have a high concentration of bullish bets in the equities market.

'Doing just fine'

Some analysts, however, doubt that a significant downturn is looming.

"We are lacking a real driver at the moment for a meaningful correction," said Eric Robertsen, head of global macro strategy and foreign exchange research at Standard Chartered. "Big U.S. fiscal package — believe it when I see it, U.S. inflation surge — no, a surge in the U.S. dollar – possible but not our base case."

Another potential market upset was eliminated when Trump decided to tap Fed Governor Jerome Powell to run the Federal Reserve instead of Stanford economist John Taylor, Robertsen said. Taylor is regarded as a proponent of raising rates at a faster pace, and so the Powell pick was widely seen as a positive for stocks.

Nevertheless, cautious investors are reducing exposure to riskier equities while raising holdings of cash and safe-haven U.S. treasuries as the year draws to a close. But they're not quite making a dash into cash as long as economy activity and corporate earnings remain robust.

"It looks to me like global equities are doing just fine. The S&P is fully valued but earnings momentum is good," Robertsen said. "We have shifted our exposure from pure yield plays to growth plays as we think the growth story is still compelling."

Global markets may be able to shrug off the impact of higher U.S. interest rates in the short term, but perhaps not over a longer time horizon. Emerging markets, in particular, may be susceptible to capital flight if higher rates mean investors flock back to U.S. assets. Local currencies could come under pressure, making U.S. dollar-denominated debt harder to service and possibly raising default risk.

"If you look at Fed monetary policy and the history of Fed policy, pretty much every major Fed tightening cycle you've had some sort of crisis in emerging markets," said Callum Henderson, managing director for global markets Asia Pacific at consulting firm Eurasia Group. "Over the longer term you could well call Fed's tightening boiling the frog."

The "frog," for its part, may be more resilient than ever before.

"Asia is much better placed than it was compared to the taper tantrum. Macro and political stability has improved. The overall picture in Asia is better," BlackRock's Seth said.