Why Wall Street sees the stock market on the verge of a ‘melt-up’

Is the market primed for a first-quarter risk-asset run?

  • By Mark Decambre,
  • MarketWatch
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Is the stock market on the brink of breaking into an unmitigated run-up to fresh records?

That is the question a number of market strategists are exploring as the Dow Jones Industrial Average (.DJI), the S&P 500 (.SPX), and the Nasdaq Composite (.IXIC), indexes mount their latest concerted assault on all-time closing highs, powered by hope that the U.S. and China can forge a preliminary trade accord to resolve a prolonged battle over import duties.

A number of other geopolitical headwinds, at least momentarily, have died down, including concerns about market-roiling effects of uncertainty surrounding the Byzantine pathway toward a U.K. exit from the European Union.

Analysts at Bank of America Merrill Lynch, led by strategists Michael Hartnett, described the market as “primed for Q1 2020 risk asset melt-up,” with the Federal Reserve and the European Central Bank still providing ample support to portions of the market and economy that have shown some signs of softness.

UBS Global Wealth Management Chief Investment Officer Mark Haefele said that a partial Sino-American trade resolution contributes mightily to the bullish thesis that a number of strategists have adopted. “This could unlock further upside for equity markets, driven by an improvement in business confidence and a recovery in investment,” Haefele wrote.

It is important to note that the a so-called melt-up is considered by market pundits as the end phase of an asset bubble and is usually, but not always, followed by a significant downturn in stock values. Strategists have predicted melt-ups a number of times over the past 18 months, with concerns growing about U.S. economic growth in its record-setting 11th year of expansion, supporting fears that an economic and stock-market pullback are inevitable.

A call by some market participants for further gains for equity indexes now comes as the S&P 500 has gained nearly 27.3% in the year to date, the Dow has returned about 21% so far this year and the Nasdaq has produced a year-to-date return thus far of about 33%, according to FactSet data.

The strong performance has also translated into outsize gains for the small-capitalization Russell 2000 index (.RUT), which is on track for a 22.3% gain, its best annual return, if it holds, since 2013, when it gained a whopping 37%. Not too shabby for the small-cap benchmark, which had been buffeted the most by concerns that the U.S. economy might take cues from anemic growth in other countries.

The S&P 500 and Nasdaq also are on track to notch their best annual gains since 2013, when the broad-market S&P returned 29.6% and technology-laden Nasdaq rose 38.32%.

Analysts at Morgan Stanley, led by Michael Wilson, chief U.S. strategist, have described the current state of bullish play as a trifecta of catalysts. Those include accommodative central banks, providing fresh liquidity to already-buoyant markets; easing Brexit uncertainty; and apparent progress toward a meaningful detente in China-U.S. trade relations.

That said, Wilson and his team say that earnings for companies will be challenged, with labor costs likely to rise among smaller-cap companies.

“However, the percentage of S&P 1500 (large-, mid- and small-cap) companies with positive forward EPS growth has deteriorated meaningfully since 2018,” Morgan Stanley analysts wrote.

“Further, the current level of this measure is worse than it was during the 2015–2016 manufacturing recession, a trend driven mainly by smaller-capitalization companies which are struggling with higher labor costs,” they said.

Partly for that reason, among others, some analysts are pointing to growing signs that Wall Street investors are becoming overcomplacent about buoyancy in the market.

Notably, one measure of risk for future downturns, the Cboe Volatility Index (.VIX), is on track for a 54% decline this year, which would mark the gauge of coming volatility’s worst yearly drop on record. The index tracks bullish and bearish options on the S&P 500 for the coming 30-day period and has tumbled below a reading of 12, well below its historical average of about 19. The index tends to rise when stocks fall and vice versa.

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