The stock market is in the midst of several major shifts, and investors should begin to reposition their portfolios appropriately, according to a recent report from the U.S. equity and quantitative strategy team at Bank of America Merrill Lynch (BofAML). "The 20-year long risky stock premium has finally been wiped out," is how their report leads off, continuing, "investors should pay for safety and be compensated for risk, but the opposite has been the case for 20 [years]." Given their observation that "the gap has finally closed," this has major ramifications for investors going forward. The table below summarizes five big market trends that BofAML sees as being underway right now.

5 Big Market Trends

More volatility ahead as the yield curve flattens and big pullbacks become more common.
Cash-rich quality stocks are poised to outperform.
Growth stocks are significantly outperforming value stocks in 2018, but the trend should reverse.
The current high-risk environment favors active fund managers adept at stock picking.
Small cap stocks are underperforming and likely to lag even more.

Source: Bank of America Merrill Lynch

Significance For Investors

At the broadest level, BofAML believes that the raging bull market is over, and that investors should expect significantly lower returns going forward. They forecast that the S&P 500 Index (SPX) will reach 3,000 by the end of 2018 and 3,500 by the end of 2025. These represent gains of just 2.8% and 20.0%, respectively, from the market open on Sept. 26. The 2025 target implies average annual gains of only about 2.2% over the next seven years, from 2019 through 2025.

Investors should expect more volatility ahead. "A flattening yield curve typically reflects decreasing growth expectations and building risk aversion, which tend to have an amplifying effect on volatility," the report says. It adds that, based on history, 3 pullbacks of 5% or more and one correction of 10% or more should be expected in each year going forward.

Cash-rich quality stocks should outperform. Tightening by the Federal Reserve, through short-term interest rate hikes and the reversal of quantitative easing (QE), will increase the cost of capital to corporations. "Cash-rich self-funded companies" will be at a distinct advantage compared to heavy borrowers and are likely to enjoy increased valuations and trade at a premium to lower-quality, highly-leveraged firms.

Value stocks are due for a comeback. Including 2018, growth stocks have beaten value stocks in 8 of the last 12 years, with one tie. "Growth is historically expensive...but typically outperforms Value in later-stage bull markets," the report notes. However, BofAML adds, "broadening profits could resurrect Value."

Active fund management is likely to outperform passive management"Idiosyncratic risk, measuring stock specifics, sits at cycle highs, similar levels to 2004." This environment favors savvy stock pickers. By contrast, BofAML finds that "risks may reside in stocks more held by passive, as they have had higher volatility than the S&P 500."

Small cap underperformance is likely to get worse. BofAML offers a host of negatives: "Small caps are at record leverage ratios, are deteriorating in quality, are less likely to retain their tax benefit, underperform when global growth lags U.S., and do not necessarily benefit from a strong USD [U.S. dollar]." They add that small caps historically underperform in later-stage bull markets and when the Fed is tightening.

Looking Ahead 

To summarize Bank of America Merrill Lynch's analysis, their clearest recommendations to investors are: expect significantly lower stock market returns and higher volatility; shift towards high-quality, cash-rich, low-leverage stocks; and rotate from small cap stocks to large caps. They anticipate that value stocks eventually will overtake growth stocks, but not quite yet, and with no specific timetable, so investors must be alert to when the signs of a definitive shift actually arise. Lastly, BofAML anticipates that the prospects for stock picking, versus passive index-oriented investing, are improving.