BANK OF AMERICA: There's glaring evidence that 2 market bubbles are fast approaching their destruction. Here's how exactly they will burst.
- "Twin bubbles" in financial markets are poised to peak in the second quarter, according to Michael Hartnett, the chief investment strategist of Bank of America.
- He explains the factors that could end these displays of "irrational exuberance," and shares his investing strategy for right now.
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The Federal Reserve has played an outsized role in simultaneously securing the longest equity bull market and economic expansion in history.
At every juncture since the Great Recession, the Fed has intervened with a lifeline. Most recently, it pumped billions of dollars into short-term lending markets last September when a cash crunch set in, and continues to provide liquidity.
But there are unintended outcomes of these stimulative measures, according to Michael Hartnett, the chief investment strategist of Bank of America.
In a note Friday, he pinpointed two broad areas where "excess liquidity" is brewing bubbles. And he provided multiple examples of their manifestations.
The first bubble is in scarce yield assets.
Sovereign bonds take the cake in this category. Bank of America data shows a record $481 billion flowed into bond funds in 2019 even as the value of negative-yielding debt soared to a record exceeding $16 trillion.
This misnomer - investors chasing assets with sub-zero yields - was so prevalent last year that another strategist concluded he was seeing "the greatest bubble ever."
While Hartnett does not size the trend as such, it is clearly a bubble in his book.
The second bubble he flagged is in scarce growth assets.
For this one, Hartnett was armed with multiple examples of investments that have caught on like wildfire because of their prospective returns.
Unsurprisingly, Tesla was his first example of present-day "irrational exuberance."
Bulls like the company because it is a trailblazer in the electric-vehicle industry. But the past few weeks have been head-scratching: shares soared 141% and then fell 29% within just 25 trading days on no groundbreaking news. Many market watchers cited a combo of short sellers being squeezed out of their bearish bets and a contagious fear of missing out.
Besides the Tesla phenomenon, Hartnett cited the boom of exchange-traded funds as another example of irrational behavior. Despite all the cost and diversification benefits of ETFs, he noted that a whopping 2,712 of them have been created over the past two years.
Yet another sign of growth excess that Hartnett cites is the private equity industry's bid to offload $1.5 trillion in unspent capital by lurching into shadow banking. According to PitchBook, the five-largest PE closes in 2019 were for buyout funds.
How the bubbles burst
Given the trends outlined above, the big question is when and how it all ends.
Hartnett pins the timing of a "big top" to the second quarter, at which point he says he will turn "rationally bearish."
As for the triggers, one that already gives Hartnett cause for concern is that the S&P 500 is soaring to all-time highs even though new capital goods orders, a forward-looking gauge of business sentiment, remains flat.
A more distant catalyst is a reversal of the Fed stimulus that has helped markets stay afloat. Hartnett envisions a scenario where investors' optimism about the election fuels animal spirits and prompts the Fed to scale back its liquidity support.
An additional trigger Hartnett envisions is that investors completely underprice the biggest risks they have placed on the back burner for now, namely an economic recession, inflation, and credit defaults.
Until these scenarios play out, Hartnett is staying "irrationally bullish" on risk assets during the first quarter. He sees the S&P 500 rising to 3,498 - a 5% rally from current levels that would mark the stock market's longest and largest bull market in history.
But once these records are in the books, all bets are off.
Get the latest Bank of America stock price here.
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