Why Stocks May Surge By Year's End, Defying Bears: Bank of America

Bank of America Merrill Lynch seems unusually bullish these days despite a series of major market sell-offs and mounting uncertainty about economic growth and corporate earnings. The firm's forecast calls for stocks to rally through the end of the year, although the gains may be accompanied by increased volatility. The bank also predicts a long-term advance in stocks that would extend a bull market that's already lasted a decade. "We believe that the holiday rally is underway." says their report. "October is known for sharp market declines, but also known for creating market lows that lift stocks into a year-end rally," they observe, adding, "Importantly, we believe the long-term trend in equity markets is higher."

However, BAML does not expect the rally to follow a smooth upward path. "Higher interest rates and the changing shape of the yield curve informs us that volatility or more extreme price movement should be expected," they warn, adding, "technical indicators on breadth and volume on this rally will be important in determining future price behavior." The table below summarizes BAML's key reasons for optimism.

What Will Drive The Rally: BAML

Source: Bank of America Merrill Lynch

While BAML is confident that a year-end rally is underway, they acknowledge that it has been a rough ride for investors recently. They note that the S&P 500 Index (SPX), the Dow Jones Industrial Average (DJIA), and the Nasdaq Composite Index (IXIC) all have posted negative total returns for the 1-month and 3-month periods ending on Oct. 31, as have 7 major international stock indices.

Nonetheless, BAML finds some key positives that they expect to fuel a rally, as outlined in the table above. Regarding equity valuations, they note that the forward P/E ratio on the S&P 500 has dropped to 14.6 times projected earnings, down from a peak of 16.3 times. With the yield on the 10-Year T-Note likely to stay below 3.25%, in their opinion, this will "ease some pressure on stocks." Also, despite strong inflation-adjusted GDP growth that is accompanied by full employment, they see "no significant pressures on inflation."

"Earnings are still positive; valuations are not too stretched...importantly, we believe the long-term trend in equity markets is higher." — Bank of America Merrill Lynch

Nonetheless, BAML does see some risks ahead. Although corporate profits are still on an upswing, "the cycle in earnings growth has likely peaked." Rising interest rates on mortgages are causing a slowdown in the housing market, a key driver of overall U.S. economic activity. If the 10-Year T-Note yield surges above 3.25%, BAML believes that this could spark another stock market sell-off. There also are signs of decelerating economic growth in China and Europe.

"Trade concerns" are another factor weighing on worldwide growth, and the economic picture in Europe is further clouded by Brexit, the ongoing budget crisis in Italy and "banking concerns." BAML also says: "the risk is that with gridlock in Washington there will be more uncertainty and businesses may slow their capital expenditures following recently strong spending."

Bob Doll, a senior portfolio manager and chief equity strategist at Nuveen Asset Management, counts himself as bullish for the long term, but he believes that the S&P 500 will be at 2,800 as of year-end, 4.0% above the Nov. 15 open, but 4.8% below its all-time high. Doll expects that the market will "bounce around with a lot of side-wise volatility," per CNBC. He says that three questions are "haunting" the market: how long earnings will remain strong, whether the Federal Reserve will hike interest rates too sharply, and the ultimate impacts of the U.S.-China trade war. Goldman Sachs is slightly more optimistic than Doll, forecasting 2,850 on the S&P 500 by year-end, a 5.8% advance from the Nov. 15 open.

Given that consumer spending is the largest component of U.S. GDP, investors should pay close attention to consumer spending data and consumer confidence surveys, BAML advises. Deterioration in these figures could be an early warning sign of weakness in the economy, in stocks, or both. Investors should focus on high-quality large cap companies right now, BAML recommends, noting that health care stocks are showing leadership right now. Meanwhile, a recent report by Goldman Sachs finds that CEOs and other top executives of major U.S. corporations are generally optimistic about the prospects for global economic growth through 2019, as discussed in another Investopedia article.