Bank of America Hartnett: Market focuses on the possibility of a big rally in US stocks to "welcome the new," the only risk is "the market being too optimistic."

Bank of America strategist Michael Hartnett stated in his latest outlook report that the market has already begun to position itself in advance for strong economic growth in 2026. Investors generally expect that measures such as interest rate cuts, tax reductions, and tariff cuts will jointly drive a rapid increase in corporate profits. However, the bank's Bull & Bear Indicator has now risen to 8.5, triggering a contrarian “sell” signal for risk assets, reflecting that current market sentiment may be overly optimistic and warning of possible correction risks.

Fund flows highlight market exuberance. Latest data show that global equities saw inflows of $98.2 billion in a single week, with U.S. stocks attracting $77.9 billion—marking the second-largest weekly inflow on record. Meanwhile, cash-like assets saw outflows of $43.9 billion, the largest since April this year.

Hartnett believes that given expectations of simultaneous fiscal and monetary easing, the probability of market gains next year has significantly increased. Continued Fed rate cuts, a new round of “QE lite,” and persistent declines in CPI inflation have all provided support for the market. However, he also warns that sentiment is now at extremely optimistic levels, and short-term correction risks should be watched.

In terms of allocation, he prefers to position for inflation to fall by going long zero-coupon bonds, mid-cap stocks, and emerging market equities, rather than simply chasing the prevailing bullish consensus on risk assets.

U.S. equity inflows reach record highs

The market is currently undergoing a significant reallocation of funds. Equities have become the primary destination, with net single-week inflows reaching $98.2 billion, of which U.S. stocks absorbed $77.9 billion, the second-highest weekly inflow on record, only behind the $82.2 billion seen in the week of December 18, 2024.

In contrast, the bond market was lackluster, registering just $7.9 billion in inflows; gold saw increases of $3.1 billion. Notably, cryptocurrencies saw net outflows for the first time in nearly four weeks, totaling about $500 million, though most analysts expect this trend will be short-lived and may quickly reverse.

The main source of this round of fund reallocation is the substantial outflow from cash-like assets. Data show that investors withdrew $43.9 billion from cash in a single week, the largest amount since April this year, clearly reflecting a sharp rise in risk appetite.

2026 Trading Strategy: Betting on Lower Inflation

BofA strategist Michael Hartnett has constructed a macro trading framework for the first half of 2026. In an optimistic scenario, if CPI falls to 2% and the 10-year U.S. Treasury yield drops to around 3.5%, risk assets will likely receive significant support.

At the same time, the report highlights several potential risks: Global liquidity may be near its peak, Fed rate cut magnitude might be less than the currently expected 150 basis points, possibly less than 80 basis points, and the BOJ policy rate could rise to its highest since 1995.

Nevertheless, several structural factors may offset these risks. This includes a possible surprise restart of quantitative easing by the Fed, a downward trend in oil prices, Trump administration measures to ease public living pressure before midterm elections, and a continued shift in the labor market toward employer dominance. These factors should help suppress inflation, yields, and the U.S. dollar exchange rate.

Bull & Bear Indicator Issues Warning

Despite positive macro outlook, BofA’s Bull & Bear Indicator has risen from 7.9 to 8.5, crossing the contrarian sell threshold for risk assets. A reading above 8.0 usually means sentiment is extremely optimistic and has historically signaled short-term correction pressure.

Since 2002, this signal has appeared 16 times, with the global equity index (ACWI) averaging a 2.4% drop following the trigger. Statistics show the maximum drawdown one, two, and three months after the signal is 4%, 6%, and 9% respectively, while the potential missed maximum gains are generally less than 2%.

However, the historical accuracy of this indicator is only about 63%, and the latest two signals showed clear deviations: after sell signals in December 2020 and July 2024, the stock market did not correct, but instead kept rising.

Structural Market Risks Begin to Appear

While overall market positions have not shown signs of overheating, some structural risks are accumulating. Growth in margin debt continues to outpace market gains, hedge fund leverage remains high, and momentum trades have persisted for some time.

The current investor concentration in AI and tech sectors is reminiscent of market structures in 2000 and 2007. At the same time, short positions remain crowded, the cash allocation has dropped to historic lows, coinciding with the impending buyback blackout period and potentially weaker support from major buyers.

More importantly, global long-term yields are generally trending higher, presenting a risk that cannot be ignored: even if the Fed continues to cut rates, U.S. long-term rates could still rise due to global factors, increasing bond market volatility and posing a substantial threat to equities.

Risk Warning and DisclaimerThe market carries risks, and investments should be made cautiously. This article does not constitute personal investment advice and does not take into account individual users’ specific investment objectives, financial situations or needs. Users should consider whether any opinions, views or conclusions in this article are suitable for their particular circumstances. Investing based on this article is at your own risk.