Wells Fargo says the S&P 500 is topping out and a correction is ahead

Published Fri, May 12 202310:36 AM EDTUpdated Fri, May 12 202311:41 AM EDT

The S & P 500 may take a leg down as shorting becomes more attractive and investors move attention beyond earnings season. Equity analyst Christopher Harvey said the index is "topping out" after nearing a 4,200-point target in what he called a pattern of "fits-and-starts." He expects the index to trade at 3,700 points in the next three to six months, which would mark a 10.4% drop from where it ended Thursday's session. Harvey said that drawdown will come as investors shift focus from first-quarter earnings season to the state of the broader economy. He called the macro economic environment "fraught with risks" due to uncertainties around the path of the Federal Reserve on interest rates, the debt ceiling, student loan forgiveness and the potential for a credit crunch or recession. The index also isn't helped by the improving economics of shorting, he said. That's because the S & P 500's year-to-date performance and the overnight bank funding rate are creating a positive carry for short bets on the index, Harvey said. The overnight rate, which is the base amount for rebates, has risen to around 5.1% from nearly 0.8% a year ago. "For those expecting an equity sell-off, we recommend patience," he said in a note to clients Friday. "The macro overhang will likely weigh on sentiment, and the improving risk/reward for SPX shorts suggests stocks will eventually trade heavy — and potentially see a correction." The index has gained 7.6% this year. At one point it relinquished all year-to-date gains as investors sold off during the banking crisis. .SPX YTD mountain The S & P 500 A move to 3,700 would mark a low not seen since last fall for the S & P 500, though he still believes the bear market ended in February. Harvey said there are some variables that can impact his admittedly bearish sentiment, including what the Fed does next on interest rates, if student loan forgiveness is approved or if the market continues to climb in the face of uncertainty. Artificial intelligence could also help the S & P 500 avoid a downturn if it prompts a productivity spike that can help cool inflation and send technology stocks in the S & P 500 up, he said. If the market does slide like he expects in the coming months, Harvey said, he may consider restoring exposure to cyclical stocks. He previously favored growth stocks while trying to reduce cyclicality heading into 2023. For those interested in shorting, Harvey recommended using income to fund a risk-mitigated call option as a way to reduce tail risk. — CNBC's Michael Bloom contributed to this report.