Stock investors could be in trouble heading into next year as the Federal Reserve continues to tighten monetary policy more than what is called for given the low level of inflation, Stifel's Barry Bannister writes.
Bannister, the firm's head of institutional equity strategy, said in a note Thursday that two more rate hikes would put the central bank above the so-called neutral rate, which accounts for inflation.
Historically when this has happened, it has triggered a bear market.
"Timing the next 20 percent bear market is difficult due to policy distortion, but 'within 6-12 months' seems assured," wrote Bannister. "History indicates that the next bear market may be quite rapid, probably exceeding the reaction time of the Fed."
The Fed has already raised rates twice this year and is largely expected to hike later this month. Market estimates for another rate hike in December are at 72.1 percent, according to the CME Group's FedWatch tool.
The U.S. central bank slashed interest rates to zero following the financial crisis in 2008 as a way to help jump start the economy. Rates remained at that level until late 2015. Given rates were kept so low for such a long time, Bannister says the Fed has no choice but to continue tightening.
"The fed funds rate has been held below the neutral rate for a decade," he said. "Weighing stability versus mandate, we believe the Fed has no realistic option other than follow its projected dot-plot path, eventually revealing the speculative excesses created in the past decade."
Bannister is one of the strategists who correctly called the February swoon that knocked the major indexes from all-time highs. The major indexes all fell more than 10 percent from their 52-week high in that decline, but have since recovered. The and Nasdaq Composite have both notched record highs recently. The Dow Jones Industrial Average has also traded within striking distance of its all-time high.
The market analyst says another indicator also points to a bear market: the equity risk premium. This measure is the market's earnings yield (inverse of the P/E ratio) minus the current yield on the 10-year Treasury. It's basically a way of showing what stocks are worth vs. bonds and currently it is showing stocks at levels of valuation that have triggered bear markets in the past, including in 2000 and 1987.
So what's Bannister doing about it? He is telling clients to get defensive and go with stocks that benefit historically when the dollar and bond prices rise. His recommended strategy includes utilities such as Sempra Energy, biotechs like Amgen, and household products companies such as Procter & Gamble.