Merrill Lynch: Why a Stock Market Crash Is Highly Unlikely

After a huge 200% run off the lows of March 2009, more and more Wall Street pundits and prognosticators are saying it is high time for a deep market sell-off. We haven’t had a 10% sell-off in more than two years, something that is quite unusual, even in a bull market. So when will it come? This week? Next month? Maybe October? If Merrill Lynch is correct in analyzing the situation, a large correction may not come at all.

A new report from Merrill Lynch Equity and Quant Strategist Savita Subramanian and her team points out that their Sell Side Indicator, which is the Merrill Lynch measure of Wall Street’s bullishness on stocks, actually fell in July to 50.8 from 51.4. What is even more incredible is that their indicator remains in Buy territory, as Wall Street’s bearishness is at the worst levels in 13-months and more extreme than at the market lows of March 2009.

More extreme than the market lows of March 2009? That seems incredible after years of the market going higher. As we pointed out before, the S&P 500 twice almost broke the 1,600 level, once in 2000 and again in 2007. Both times the stock market sold off hard, keeping investors stuck in essentially a 14-year secular bear market. Not until we actually broke out through the 1,600 level in the spring of 2013 was the long-running bear market finally concluded.

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The Merrill Lynch report goes on to say that given the level of current market bearishness, it would be very unlikely to see a huge market sell-off. Those usually accompany a period of bullish frenzy that ultimately turns frothy, like the late 1990s dot-com explosion. In fact, many market strategists at firms around Wall Street actually are suggesting their clients underweight equities now. Hardly a sign of rampant bullishness.

Despite the fact that the S&P 500 has risen more than 40% since investor sentiment bottomed in 2012, the Merrill Lynch team points out the past history suggests that strong equity returns can last for years after market and sentiment bottoms. The early to late 1990s is a good example of that.

The actual target for the Merrill Lynch indicator on the S&P 500 is a stunning 2,313, or 20% higher than current levels. While that is not the firm’s posted target for the index, their model takes into account, valuation, sentiment and technicals. Historically, when the Merrill Lynch indicators have been this low or lower, total returns have been positive over the next year an astonishing 100% of the time, with median one-year returns of an eye-popping 27%.

With Wall Street firm’s Sell Side indicator recommending equity portfolio allocations of just 51% versus the normal historical benchmark of 60% to 65%, the Merrill Lynch analysts stress that this is ultimate contrarian indicator. The bottom line is that when Wall Street is bearish, it is typically bullish for investors, and vice versa.

Is it possible for the market to have a continued sell-off here? Absolutely. However, the chances of some major collapse in the market and a return to a long-running secular bear market seem highly unlikely. Interest rates will continue to stay low, and the Federal Reserve may not raise the benchmark Fed Funds rate for another year, despite hawkish rhetoric from some members recently.

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Lastly, for many investors, it is impossible to jump in and out of the market like so many commentators seem to always be doing. It is too expensive from a commission standpoint, and in many cases may light up more capital gains than necessary. What is prudent is to take long-term gains, if you have them, and keep some cash handy, so if we do see a 3% to 5% total correction either now or later in the fall, there is some dry portfolio powder to load up on top stocks that have become cheaper.