Bank of America has found the formula for a market meltdown — and we’re dangerously close

REUTERS/ Mick Tsikas

• Bank of America Merrill Lynch has identified a series of thresholds that need to be breached in order for the market to see a correction.
• The indicators in question include GDP, wage inflation, 10-year Treasury yields, and the S&P 500 equity index.
• BAML has repeatedly warned against investor overexuberance. Meanwhile, investors have poured a record $58 billion into stocks over the past four weeks.

The scorching-hot stock market is fresh off yet another week of new record highs, yet one glaring question remains: When will it all come crashing down?

The global investment strategy team at Bank of America Merrill Lynch has an idea.

The firm, which has repeatedly warned of investor overexuberance, has identified what it sees as the perfect storm for a stock market correction — traditionally defined as a 10% selloff — and it involves four different metrics crossing particular thresholds.

According to BAML’s analysis, such a reckoning will occur once (1) real gross domestic product (GDP) forecasts rise above 3%, (2) wage inflation climbs higher than 3%, (3) the 10-year Treasury yield exceeds 3%, and (4) the benchmark S&P 500 surges above the 3,000 level.

As BAML chief investment strategist Michael Hartnett puts it: “Three is the magic number.”

So how near are we to those levels? Some might say too close for comfort. Let’s break it down:

• GDP — Economists surveyed by Bloomberg have an average forecast of 2.6% for 2018. However, a handful of the 89 participants see GDP finishing the year at or above 3%, most notably ING Group (3.1%) and Pierpont Securities (3%).
• Wage inflation — This is the measure that’s closest to 3%, with a reading of wage growth from the Atlanta Fed at 2.9% as of year-end 2017. In fact, it was above the threshold for every month of last year until December.
• 10-year Treasury yield — It’s currently at 2.64%, putting it less than 40 basis points from the 3% threshold. And it’s heading upward, having climbed 61 basis points since reaching a low in early September.
• S&P 500 — The benchmark equity index closed at 2,810.30 on Friday, putting it just 7% from the 3,000 threshold. It’s already climbed more than 5% since the start of 2018.

To further drive home just how confident investors still are in the stock market, even at record levels, look no further than recent flows into equity funds. BAML calculates that traders poured a “massive” $58 billion into stocks over the past four weeks, the most ever for a period of that length.

Bank of America Merrill Lynch

Still, BAML is constructive on stocks in the immediate term due to a combination of continued global central bank accommodation and strong corporate earnings growth. Hartnett himself has admitted that the current 8 1/2-year bull market could continue as long as the so-called “Goldilocks” economy persists — one characterized by high growth and low inflation.

Meanwhile, experts across Wall Street remain bullish on the stock market. They expect the S&P 500 to finish 2018 at 2,950, which is roughly 5% higher than current levels, according to the median forecast of 23 equity strategists surveyed by Bloomberg.

The main takeaway here should be that while pessimists like Hartnett have thrown in the towel in the near term, there’s still significant risk lurking under the surface of the market. And now, thanks to BAML’s handy threshold list, you know what to keep an eye on.