Bank of America says the warning signs that stocks are hurtling into bubble territory are growing — and pinpoints 6 that could signal a bear market is beginning

  • Bank of America's Bull and Bear indicator showed sentiment climbed, on a 1-10 scale, to 7.1 last week from 6.7 on December 17.
  • This prompted Bank of America's Chief Strategist Michael Hartnett to say in a January 7 note that investors were rationalizing "increasingly irrational price action on Wall St."
  • Hartnett laid out six warning signs to watch that could signal a bear market is beginning.
  • Visit Business Insider's homepage for more stories.

Investor sentiment has climbed from rock bottom last March to what is now approaching extremes on the other end of the spectrum — and it's starting to worry Bank of America's top strategist.

As investors react to the prospect of more robust fiscal stimulus, interest rates remaining low, and the Federal Reserve continuing to pledge their support, they are rationalizing "increasingly irrational price action on Wall St.," Michael Hartnett said in a January 7 note.

His comments come at all-time highs for stocks, and as the bank's latest Bull and Bear indicator showed sentiment had climbed, on a 1-10 scale, to 7.1 last week from 6.7 on December 17. The bank labels ratings above eight as "extreme bullish" territory, and advises investors to sell when the indicator reaches those levels. In March, the indicator's reading was 0.

Bank of America

Bank of America

In the note, Hartnett said he expects sentiment to keep rising over the next month or two, and that "peak positioning" will be in February or March. 

"We'll know if it's a bubble by end-Q1," he said.

Hartnett said the most dangerous risk to the market's current valuations are rising 10-year Treasury yields, which will eventually cause investors to step out of growth stocks. 

He pinpointed six warning signs to watch out for that could signal interest rates are posing a threat to riskier assets:

  1. The iShares' Investment Grade Corporate Bond ETF (LQD) drops below $133; and/or banks start to lend more

  2. The US Dollar rises surprisingly if Europe and Asia see weaker growth 

  3. The Chinese Yuan and Shanghai Composite fall with Chinese bond yields as a result of weaker growth

  4. Inflation rises. Hartnett points out that food prices are at six-year highs, and are up 20% over the past eight months

  5. Higher yields lead to losses in "speculative favorites" like Tesla and bitcoin

  6. Popular low-rate plays like the SPDR S&P Homebuilder ETF (XHB) and the PHLX Semiconductor Sector Index (SOX) fall

Hartnett also highlighted risks to a bubble in financial markets.

These include heightened wealth inequality and political and social polarization; the fact that the value of US financial assets is now six times the size of GDP; price action on IPOs and SPACs growing "increasingly speculative"; extreme wealth gains, which have been a symptom of the end of recent bull markets; and investors ignoring rising rates.

Hartnett also seemed to express concerns about bitcoin's rally over recent weeks. He included a chart, below, with the title: "Bitcoin, the mother-of-all-bubbles?" He also included a flow-chart, also below, showing the projected next step for bitcoin following the current speculative craze is a correction. 

Bank of America

Bank of America

Hartnett among others

Hartnett isn't the only prominent strategist on Wall Street expressing concern about investor sentiment levels. 

Charles Schwab's Chief Investment Strategist Liz Ann Sonders told Business Insider in December that sentiment was getting "frothy," and warned that this would make a market sell-off more severe when eventually triggered by a catalyst.

More specifically, she said investors should be worried about a deterioration in fundamentals if sentiment keeps rising.

"Where you tend to get a bigger problem is if sentiment is really, really elevated, and then you start to see a brisk deterioration in the market but sentiment just stays optimistic," Sonders said. "That to some degree is what happened in the early part of 2000. You started to see some underlying deterioration in what was going on in the market, but sentiment was like, 'nope, doesn't matter, it's a new paradigm.'"

Several renowned bears, like David Hunter, Jeremy Grantham, Albert Edwards, and Mark Yusko, have also warned of valuations reaching stretched levels in recent months.

Major Wall Street banks have also laid out the threats that could derail the stock market in 2021.

But while overall sentiment and valuations remain high — namely in mega-cap tech stocks — many see gains ahead in 2021. 

Virtually all of the biggest investment banks on Wall Street have positive price targets for the S&P 500 this year, as the anticipated economic recovery is expected to boost profits.

Get the latest Bank of America stock price here.

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