The stock market is ‘dancing on the rim of a volcano,’ warns investment bank

A couple of scientists standing on the crater rim of Erta Ale - one of the most active vulancoes in the world with an active, red glowing lava lake.

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Investors are too optimistic and taking on too much risk in this low volatile environment, setting the stock market up for a potential downfall, according to strategists at investment bank Societe Generale.

“In a goldilocks scenario of low interest rates, abundant liquidity, stable growth and a focus on the ‘good’ Trump, investors continue to push asset prices, volatility and leverage to historical extremes,” said Alain Bokobza, head of global asset allocation at Societe Generale, in a report Monday. “Yet, a low volatility carry environment with rather extreme positioning is a dangerous combination, which we recently likened to dancing on the rim of a volcano.”

Bokobza also compared U.S. stocks to the boiling frog that doesn’t realize the trouble surrounding it.

“Today’s current dynamics put the US equity market at a similar risk as the frog,” he said.

U.S. stocks have been on fire this year. The S&P 500 is up more than 15 percent in 2017, boosted by strong corporate earnings, expectations of a U.S. tax code overhaul and improving global economic conditions. Monetary policy — which has been a boon for stocks since the financial crisis — also remains loose compared with historical standards.

But Bokobza said the S&P 500 is richly valued despite the uncertainty around Congress and the Trump administration passing tax reform.

There is “a growing risk that tax cuts cannot be passed in Washington, or will be more modest than expected. Such an outcome could raise the risks of a recession,” Bokobza said, adding that some expectations of tax reform have already been priced into the market.

The House passed a bill last week that would immediately lower corporate taxes to 20 percent from 35 percent. But the Senate still has to vote on its own bill and there are key differences between the two.

The most significant difference between the chambers’ plans is the treatment of state and local tax deductions. The Senate plan would eliminate those deductions entirely. The measure could alienate some House Republicans who voted for the chamber’s bill that would allow up to $10,000 in property tax deductions.

Valuations have also been boosted by investors’ fear of missing out (FOMO) on the latest bull rally and continuous inflows from stocks via passive investment strategies, Bokobza said. “Passive flows into the US equity market have been high over the past few years as has the momentum trend, exacerbating the S&P 500‘s bullish trend.”

Another red flag the market is raising is growth in margin debt levels among companies listed on the New York Stock Exchange.

“The growth in margin debt has not reached exorbitant levels yet, as was the case just before the 2000s and 2007s market crashes,” he said. “However, we expect to enter a bear equity market environment, and the sell-off may be exacerbated by margin calls being triggered.”

Overall, Bokobza said he and his team do not expect a market crash or a financial crisis to hit near term. “However, we believe that the S&P 500 is showing an asymmetric risk/reward profile,” adding that a bear market “is not so far in the distant future.”

Societe Generale expects the S&P 500 to fall 22.5 percent from its Monday levels to 2,000 by the end of 2019.

— CNBC’s Patricia Martell contributed to this report.

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