Bank of America says the midterm elections could be a major turning point for the stock market

The bull market could run into its next big hurdle in a few months’ time, Bank of America says.Strategists flagged the risk of a “big” reversal in stocks following the midterm elections in November. In a recent note to clients, the bank pointed to the possibility of a Democratic sweep in Congress as the election amounts to a “referendum on populist capitalism vs populist socialism.” A team led by Michael Hartnett wrote in a note on Friday that investors should eschew risky assets and head into defensive investment in the near-term.He added that the bank likes gold as an investment to hedge risks of the K-shaped economy and an electorate that delivers an “it’s the economy, stupid” midterm result. Economic dissatisfaction has been a growing concern for the lower leg of the K-shaped economy, which refers to the widening gap between the top earners and lower- to middle-income households. While top earners are benefiting from higher stock and real estate prices, many lower- to middle-income Americans are feeling the cumulative effects of hotter inflation and a tough job market. Recent growth in the economy has largely been fueled by the wealth effect from higher stock prices, BofA strategists said, pointing to the $9 trillion in market gains investors have seen over the past two years. A reversal in the market is a risk to economic growth, as dwindling wealth on paper could cause consumers to rein in spending. Separately, the bank floated the possibility that yields could move higher as investors continue to worry about inflation and the country’s fiscal outlook. In a bear-case scenario, yields could reach levels that would materially weigh on risk assets, leading the AI bubble to pop.

“Bonds end booms and bubbles, and this one ends once ‘higher yields-lower dollar’ vigilante event forcing fiscal policy U-turn, and asset allocation from stocks to bonds rise,” strategists said, adding that rising yields are a “canary in the coalmine” they’re watching. Yields have already started to rise as investors fret over hotter inflation, though the increase so far has been tolerated by markets. The 10-year US Treasury yield is sitting at around 4.67%, above the 4.5% psychological threshold closely watched by investors.Other forecasters on Wall Street have flagged the potential for a surge in volatility as the midterm election approaches.In midterm years when the president is in his second term, the S&P 500 tends to see a correction in the third quarter, analysts at Oppenheimer said in a previous note.In all midterm years since 1974, the S&P 500 has seen a median return of 0% from August 1st through the election day in November, strategists at Goldman Sachs said in a past report.