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Bank Of America: "This Is The First Sign That A Bubble Has Arrived"

Lately, fund flow data has all the credibility of a NYT presidential poll two days before the Trump defeats Hillary.  On one hand, you have Lipper reporting that investors pulled $16.2bn from U.S.-based equity funds in the past week, the largest withdrawals since December 2016. The same Lipper also reported that taxable-bond mutual funds and ETFs recorded $1.2bn in outflows, with U.S.-based high-yield junk bond funds posting outflows of $922 million. On the other hand, you have EPFR which looking at the same data, and the same time interval, concluded that there was $8.7bn inflows into equities, of which total flows into the US amounted to $7.8bn, the largest in 26 weeks.

How does any of this make sense? We are not sure, although it may be that while Lipper ignores ETF flows, EPFR includes these. Indeed, when breaking down the latest flow data, which still does not foot with the Lipper numbers, Bank of America notes that the $8.7bn in equity inflows is the result of a $31.4bn in ETF inflows - the second largest on record - offset by $22.7bn in mutual fund outflows, the 4th largest on record.

When looking at this staggering divergence, BofA's Michael Hartnett put it best:

Passive hubris, active humiliation: 2nd largest week of inflows ($31.4bn) ever into equity ETFs vs 4th largest week ever of outflows from equity mutual funds (Chart 1)

And while we can agree with Hartnett that hedge funds are begging for a market crash (and if they aren't, they should be), as the alternative is slow, painful, uncompensated extinction, we still have no idea if last week was near record in inflows or outflows... and we certainly don't know how much of these funds flows were sourced from the SNB, BOJ and other activist central banks who print money to buy stocks.

Less controversial are the rest of Hartnett's fund flows observations, the first of which is that  "investors respond to Fed hike & US tax reform with biggest inflows to US large cap since Apr'17 and biggest inflows to US value since Mar'17;" These were offset by redemptions from Europe (largest in 65 weeks), EM equities.

The flows led to a historic moment: whether due to the latest inflows into ETFs (and outflows from active funds), or some other reason, in November, US equities rose to an all-time high vs government bonds, exceeding Dec'99 peak.

Taking a step back from fund flows, Hartnett reminds us the he has aggressive "Icarus" bullish Q1 targets of SPX 2863, CCMP 8000, GT10 2.85%, EUR 1.10, JPY 119; he also maintains a view of Big Top in risk assets early-18, which means the crash will take place in just a few months.

He near-term optimism is justified by, what he calculates, to be a run-rate GDP of over 5%: "US small business, manufacturing, homebuilders and consumer confidence strongest in aggregate since the early-1980s, consistent with 5-6% US real GDP growth (Chart 4)."

However, this soaring growth - granted almost entirely in the realm of meaningless, self-reported surveys - comes at a time of zero inflationary expectations. To wit, rate expectations remain extraordinarily low: next 3 years total market-implied tightening by the Fed, ECB & BoJ is 81bps, 46bps and 4bps respectively.

And while excess bullishness won't take long, the big missing ingredient for Big Top & Big Rotation is inflation: recent BoE study shows most important driver of bond bear markets is inflation, not GDP or budget deficits.

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Putting all of the above together, Hartnett again warns that the Big Risk therefore remains the absence of Main St inflation inducing Wall St inflation (i.e. bubble), which in turn becomes driver for big tightening of financial conditions and volatility. Said otherwise, sooner or later, the Fed will be forced to pull Wall Street's punchbowl, and since this is the biggest equity bubble of all time, the results would be catastrophic.

Hartnett is kind enough to leave us roadmaps for what happens next: Japan 1989, US 1999, China 2007 are the bubble roadmaps because they all saw bull markets mutate into bubbles and higher bond yields; To wit: the NKY jumped 31% as JGB yields rose 170bps; CCMP jumped 230% as Treasury yields rose 220bps, SHCOMP rose 200% as Chinese yields rose 160bps.

Finally, here - according to BofA's Chief Investment Strategist - is the first warning sign of bubble (besides "Da Vinci, bitcoin"), which would be the divergence between credit and equity prices in technology (Chart 7).