Here's why the stock market could peak the day Trump signs the tax-cut bill

- Optimism has surged, which could be a risk -

By RyanVlastelica, MarketWatch

Expectations for corporate tax cuts are credited with boosting the stock market to repeated records, but optimism over the legislation means its passage could mark a near-term peak for equities.

Earlier this year, Morgan Stanley forecast a market top "the day President Trump actually signs the tax bill." This view, the investment bank wrote on Monday, "is still quite valid."

Equities have risen in nearly uninterrupted fashion all year, with Wall Street enjoying both its quietest year in decades, as well as a record number of closing records. On Monday, major indexes hit all-time highs on growing confidence congressional Republicans will succeed in getting a major tax bill passed. Speaking on several Sunday talk shows, Treasury Secretary Steven Mnuchin said he has "no doubt" that the GOP's tax bill will make it to the desk of President Donald Trump this week.

While experts disagree on what the passage of the tax bill could mean for the economy-in terms of accelerating hiring or improving wages-it is expected to fuel further equity gains by cutting the corporate tax rate, among other changes.

Optimism over the plan has driven the market to repeated records in a short period, and the S&P 500 has nearly met Morgan Stanley's target of 2,700, a level the bank didn't expect the benchmark index to hit until the first quarter of next year. The speed and scale of the rally makes the bank jittery, especially since they feel it has been accompanied by signs of the kind of euphoria that have historically marked tops.

According to the latest AAII Sentiment Survey, 45% of polled investors describe themselves as bullish, meaning they expect the market will be higher in six months. That's a jump of 8.1 percentage points from just last week, and it is well above the historical average of 38.5%. The percentage of bearish investors, meanwhile, is at 28.1%, below the 30.5% long-term average and down 6.1 percentage points from last week.

The rise in positive investor sentiment is "perhaps the most significant reason to be less bullish now versus a year ago," Morgan Stanley wrote, adding that "animal spirits have rarely been higher."

Chart courtesy Morgan Stanley

The firm cited both consumer confidence and small-business optimism for this view, but added that Wall Street analysts were similarly bullish. "The sell side now appears to be competing to see who can have the highest price targets with many more now predicting double digit returns for 2018."

According to a MarketWatch analysis, strategists expect the S&P 500 to end 2018 at 2,819, which would represent upside of about 4.8% from current levels.

This bullishness is showing up in how both institutional and retail investors are positioned. Institutions are "loading the boat on risk," Morgan Stanley wrote, "with long/short net and gross leverage as high as we have ever seen it."

It added that "even the retail investor can't stay away," noting that cash balances for Charles Schwab clients reached their lowest level on record in the third quarter.

Chart courtesy Morgan Stanley

Chart courtesy Morgan Stanley

"It's hardly coincidental that this broad shift in both institutional and retail positioning is happening alongside the very visible tax reform legislation," Morgan Stanley wrote.

There are still plenty of positives in the economy's favor, including improving data, a strong labor market, and growth in corporate profits. Such tailwinds could support the market over the long term, even if it stalls over a shorter time horizon, Morgan Stanley speculated.

The peak on the day the bill is signed "may not mark the final cycle top but instead an interim one that is tradable or at least something to think about as we exit 2017," it wrote to clients.

From MarketWatch