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2018 could see 'euphoric' trading to start but shallower year end gains —Bank of America

Patti Domm
Tim Boyle | Bloomberg | Getty Images. Bank of America Merrill Lynch strategists see the S&P 500 ending 2018 six percent above current levels.

Bank of America Merrill Lynch strategists see the S&P 500 ending 2018 six percent above current levels, but they say it could be the year when the aging bull sees late stage euphoria. BofA strategists expect stocks to outperform bonds for a seventh consecutive year in 2018, a run not seen since 1928. They are overall bullish on stocks, bearish on bonds, long U.S. dollar, and long on volatility. Savita Subramanian, Bank of America chief U.S. equity and quantitative strategist, does not yet see euphoria, which would indicate a coming end to the bull market. Her year end target of 2,800 is just above the median 2,750 forecast of 11 other equity strategists surveyed by CNBC. The forecast gain for 2018 is modest when compared to the gain of 18 percent for the S&P 500 so far in 2017. The strategists unveiled their outlook at a briefing Tuesday. Michael Hartnett, BofA head of global investment strategy, said the S&P could run up as high as 2,850 in the first quarter before a sharp mid-year sell off. "Our overall outlook for the year ahead is macro bullish, so much so that we're ultimately market bearish," said Hartnett, who has a different view than the U.S. strategists. "We think euphoria is what's going to end this bull market and we're not there yet," Subramanian said. "We're not at the point where the investment community is saturated in equities and there's nothing to do with stocks but sell." Subramanian said her model does not yet show a correction, in a later interview on CNBC. Subramanian said she watches the market calls of other Wall Street strategists and they are not indicating too much bullishness. "We still think there's a ways to go before we have Wall Street telling you to back up the truck on stocks," she said. "Your average Wall Street strategist is telling you to put about 55 percent of your wealth into equities. While this is a lot higher than what Wall Street was recommending in 2012, when they had thrown in the towel on stocks," Subramanian said. "55 percent is still well below the levels of euphoria that herald the end of a bull market." The BofA strategists are more bullish on tech and materials for 2018, but they warn inflation could be a risk. "Our proprietary indicators suggest that inflation pressures are building, which could not only hasten Fed tightening," they wrote in the note. Other risks include geopolitics, a credit crunch, a more hawkish Fed and the end of quantitative easing. The strategists raised tech to overweight from market weight and boosted materials to overweight from underweight, because of its momentum. Technology has been selling off in recent sessions due to concerns it will benefit the least from tax reform and could be impacted negatively on research and development. They view the bull market as being in its late stages and for that reason see momentum as the best way to invest. Momentum usually outperforms by 22 percentage points in the 12 months before the market's peak, they note. High dividend yielding stocks and small caps tend to under perform during that stage so they prefer large caps. Tax reform is the earnings "wild card for 2018" and is a potential upside risk to their forecast. The strategists see 6 percent earnings per share growth for the S&P 500, about half the consensus expectation. "Tax reform should not be a reason that your pounding the table bullish for equities," Subramanian said. A corporate tax rate of 20 percent and repatriation driven stock buybacks could add as much as $19 to S&P 500 earnings, with $3 from the buybacks, according to the BofA strategists. Subramanian said a concern is how much of the tax break impact will be lasting, and not just "competed away." They expect $11 or 8 percent to be a recurring benefit to earnings. In other stock sector moves, health care was lowered to market weight from overweight due to decelerating fundamentals and increased positioning risk. Real estate was also reduced to underweight from market weight, as it and utilities are most exposed to the risk of dividend yield trades falling out of favor. The strategists also maintain their overweight on financials and underweight on utilities and consumer discretionary. The BofA strategists had a bull case target of 2,700 on stocks for 2017, and a bear case of 1,600, but Subramanian said the strategists weighed other concerns when setting their target below current market levels and their model was more correct.

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