JPMorgan says stocks are so crowded they may crack at any time

It’s the talk of the stock market: What will be the sign that the five-month rally in US equities is coming to an end? If you ask JPMorgan Chase’s Dubravko Lakos-Bujas, investors may not see it coming when it hits.

The Wall Street giant’s chief global equity strategist warned clients recently that they could be “stuck on the wrong side” of the momentum trade when it eventually falters, and he encouraged them to consider diversifying their holdings and think about risk management in their portfolios. He also reiterated his warning that excessive crowding in the market’s best-performing stocks raises the risk of an imminent correction.

“It just might come one day out of the blue. This has happened in the past, we’ve had flash crashes,” Lakos-Bujos said in a webinar. “One big fund starts de-levering some positions, a second fund hears that and tries to re-position, the third fund basically gets caught off guard, and the next thing you know, we start having a bigger and bigger momentum unwind.”

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His remarks came after the final trading days of a strong first quarter for stocks, with the S&P 500 Index on track for a roughly 10% return. The broad US equities benchmark posted its fifth consecutive month of gains as corporate earnings remain strong, enthusiasm around artificial intelligence keeps building, the US economy continues to be healthy and the Federal Reserve signals its willingness to cut interest rates this year

But to Lakos-Bujas, that list actually is a reason for concern.

“A lot of goodies have gotten priced in,” he said, from earnings and Fed expectations, to even a potential election victory for former president Donald Trump, which he said would be viewed as helpful for the market. Moreover, he sees few sources of upside surprise beyond Nvidia Corp. and the prospects for AI innovation. “That source of upside surprise is becoming more and more limited, and on the flipside, you do have more risks that are hovering in the background,” he said.

Moreover, looking at recent history, the rush into popular momentum stocks like the Magnificent Seven typically is followed by a correction. It’s happened three times since the Global Financial Crisis.

“Historically, whenever you had such a high degree of crowding it was a question of weeks before the momentum factor faced a big fat left tail unwind,” Lakos-Bujas said, pointing to Tesla’s 29% plunge and Apple’s 10% drop (prior to Thursday’s trading) this year after strong 2023s as examples of what’s to come.

“Who is going to be the next one — and when?” he said.

Lakos-Bujas and other strategists at JPMorgan, including Marko Kolanovic, have been among few bearish contrarians on Wall Street this year. As most of their peers raise their US equity outlooks, with the stock market continually setting new highs, they have remained pessimistic that the gains would stick. Among the big Wall Street banks, the firm holds the lowest year-end target on the S&P 500 of 4,200, implying a drop of nearly 20% from today’s level.

It is worth bearing in mind at this point that the bank’s house view on US equities has failed to materialize for two consecutive years as Lakos-Bujas and Kolanovic remained bullish throughout most of 2022’s rout and then held a bearish stance during last year’s 24% rally in the S&P 500.

It is always possible to get opposing views; you can often find them within the same bank and Wall Street analysts are often wrong, even though they start with a 50/50 scenario.

The fact is, stocks rally and stocks fall. The recent rally has been remarkable, but it is often just when investors get comfortable that things start to go wrong.

We have been of the opinion for a long time that the Fed wouldn’t be able to cut US interest rates as much as the 1.25% that was being priced in towards the end of last year – the prediction that started the rally. The fact that the market is now looking for less than 0.75% in cuts hasn’t had much of an impact on the market, but perhaps it should.

On top of that, if the 0.75% becomes even less, or worse goes below 0% and the Fed start talking about the next move being a hike, well that would create chaos.

 We feel the recent inflation data has been very much underplayed. If this was UK inflation, the papers and financial commentators would have plastered it all over the news everywhere. The fact is inflation in the US is on the rise. It’s not a ‘bump in the road’ as it has been gradually increasing since last October (again, the start of the rally when the 0.1% month-over-month print was released).

US CPI month over month

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This is most certainly not the trend the Fed was looking for. As you can see from the September drop, drops can happen very quickly. However, the October print is actually the one that looks like the outlier and not the norm.

For the US to hit its 2% inflation target, the month-over-month average needs to be around 1.6%. The Fed has said that they could handle higher than normal inflation for a while, and they like to look at the PCE numbers as their main data point, but ignoring the actual inflation number is hard to do.

Compare US inflation above, to the below same chart of UK inflation on a monthly basis.

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Nobody is saying that the fight against inflation in the UKis over, but it certainly looks better than it does in the US.

It’s hard to see how stocks climb from here, but the marketis hard to predict and the one thing we can be sure of, anything can happen.

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