Stocks are ripe for a pullback early next year, according to BCA Research.
Strategists at firm said US equities will rally into January before falling over 20% at some point in the first half of the year, meaning investors should get defensive and hedge risk.
The analysts, led by chief US investment strategist Doug Peta, point to a slew of data points that signal a weakening economy as the tailwinds from pandemic-era policies fade.
First, they pointed to a slowdown in consumer momentum after a surge in "revenge spending" following the COVID-19 pandemic.
Now, data shows that the trend may be diminishing, even though households are broadly better off than before the pandemic. Compared to the end of 2019, US consumers have seen a surge in home equity and household wealth amid the stock market's stellar rally, the analysts said.
Consumer-facing companies have raised warning signs of less spending, with revenues at Home Depot and Lowe's slumping even amid surging home equity, which formerly signaled a pickup in home improvement spending. Earnings calls from other big retailers like Walmart and Target, meanwhile, have signaled a rise in bargain hunting as consumers tighten their budgets.
"Revenge spending appears to have run its course, and a widening range of retailers report that consumption momentum has faded," the analysts said in a Monday note.
Second, the BCA analysts pointed to a softening labor market, with October employment data showing the job openings rate climbed from a four-year low from September back above its key 4.5% threshold, while the quits rate rose and the hires rate slipped to revisit a four-year low it set back in June.
That "one-step-forward-two-steps-back" trend preserves the possibility of a soft landing, but remains a sign of softening that could lead to a recession, the analysts said.
"We expect that continued softening will eventually provoke a wave of layoffs, triggering a vicious circle in which shrinking payrolls beget slower spending, begetting further payroll contraction and still slower spending growth until businesses slash discretionary investment and a recession ensues," the analysts said.
Finally, they highlight heightened risks from historically high stock valuations . The S&P 500 is trading at 23 times above annual earnings, nearly two standard deviations above its mean, while analysts project earnings-per-share growth of 13% in 2025, nearly double the 6.6% postwar average.
Such extreme valuations make risk assets vulnerable to even slight disruptions, the analysts said, and with financial markets discounting the probability of a recession , that makes stocks a risky investment.
"Although we believe a 2025 recession is more likely than not, risk assets could disappoint even in the absence of a recession, and current prices do not augur well for future returns," they said.
Those three growing trends pose an outsize risk to the stock market's two-year bull rally , the analysts said. As a result, they recommend rotating out of stocks before buying the dip in the event of a sharp decline.
"We nonetheless expect an equity bear market will unfold sometime in the first half and will be looking for an opportune entry point to position against equities if our stop is triggered. We will be eager to narrow the underweight soon after the 20% bear-market threshold is reached and will likely look to overweight equities around -30% to -35%, if they fall that much," they say.
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