‘Easy Money’ Era in Closing Act?

Terry Flanagan

Liquidity has been at the forefront of a period of excess market returns, but that dynamic is in its closing stages, according to Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch Global Research.

The reason is simple: the economy is gaining momentum.

“You’re moving away from the most maximum bullish backdrop for assets, which is falling rates, accelerating liquidity and rising earnings, to one of being much more reliant on earnings,” Hartnett said at a press briefing on Tuesday. “The rates card and the liquidity card have been played as aggressive as they can be played.”

BofA’s recommendations to investors going into next year are (in order of conviction): bullish dollar, bullish volatility, bullish stocks, bearish rates, and opportunistic in commodities and emerging markets. “The view that that emanates from is a very simple one, which is that the era of maximum liquidity and maximum returns is behind us,” Hartnett said.

The Dec. 5 payroll report is the latest signal that the economy is starting to heat up. BofA is still bullish on markets but it’s a much more cautious optimism than in recent years and that’s reflected in its return assumption of 4% – 8% total return from global equities, coupled with a projected hike in interest rates by the Federal Reserve.

BofA is forecasting 7% returns on the S&P 500 for 2015; 2,200 is its official year-end target. It’s looking for about 5% positive earnings growth from the U.S. corporate sector, so S&P earnings should hit about $124 by the end of next year. “You’d think there’s a lot to like within the S&P 500, but this is the lowest return we’ve baked into our forecast since I’ve been covering the equity strategy role,” said Savita Subramanian, head of U.S. equity and quantitative strategist at BofA Merrill Lynch Global Research.

Savita Subramanian, BofA Merrill Lynch

Savita Subramanian, BaML Global

Stocks aren’t expensive at current levels but they’re no longer as cheap as they were a couple of years ago. “Two or three years ago or even early this year, the S&P looked much less expensive than it is today,” Subramanian said. “Valuation is no longer a strong support for the market.”

BofA’s has found its sentiment barometer, which tracks average recommended allocations to equities by its counterparts on Wall Street, to be a reliable contrarian metric. Two years ago, in Wall Street basically threw in the towel on equities, going a record low 43% allocation to equities, which was “a real sign that we were at a point where you wanted to go long the market,” said Subramanian.

Today, the consensus has risen to a 50% allocation to equities, which is “still fairly tepid in the grand scheme of things where the benchmark has been closer to 60%-65%,” said Subramanian. “So the community of investors are less bearish than they were a few years ago” which means there’s less upside.

The biggest kind of alpha generator over the last year is an unusual one, she said, which was to simply buy the stocks that the active community hated or were most underweight and sell the stocks that were most crowded within the active management community.

“The stocks that were the darlings of long-only funds sold off by quite a significant margin and stocks that were very underweight actually rallied the most this year,” said Subramanian. “Part of this is the big bet on rising rates that has still failed to materialize.”

Subramanian stressed that it’s very important to retain that contrarian bias. “This is the time to think about what everybody is doing, and do the opposite and expect to continue to see attrition out of active funds into passive. Volatility is generally good for stock pickers because it creates opportunities, dispersion, and performance.”

Large-cap stocks have healthy balance sheets yet are still quite inexpensive. “The active community might need to revisit their chronic bias,” said Subramanian. “Active large-cap managers tend to always be overweight small-cap companies and that could continue to hurt them going forward. We could be setting up for a very good stock-picking year but it does require the active community to revisit some of their biases.”

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