'Sell the first rate cut': Bank of America's top global strategist warns stocks could be in for trouble as the economy heads toward a hard landing and the Fed gets set to slash rates

• Bank of America's Michael Hartnett advises selling stocks at the first Federal Reserve rate cut.
• Hartnett's analysis of past rate-cutting cycles shows stocks fall during hard-landing cuts.
• Recession risks have been underappreciated by investors, Hartnett said.

Bank of America's Michael Hartnett isn't very optimistic about the future of the US economy and stock market.

In an August 1 note to clients, the bank's top global strategist urged investors to sell stocks when the Federal Reserve issues its first rate cut. He believes the central bank will be slashing rates into a hard-landing scenario for the economy.

Hartnett and his team studied the last 12 rate-cutting cycles going back to 1970 and identified three varieties of rate cuts. One is the Fed panics from a financial crisis of some sort; another is the Fed cuts into a soft landing with no recession; and the third is cutting into a hard landing with a recession.

In the first two scenarios, the S&P 500 has risen on average over the following three- and six-month periods. But when the Fed cuts into a hard landing, stocks have fallen by 6.2% in the three months following the first cut and 3% over six months.

"We say 'sell the 1st cut,'" Hartnett wrote.

The analysis showed that hard-landing cuts occurred in 2007, 2001, 1989, 1981, 1980, 1974, and 1973.

Hartnett said surging global central bank rate cuts are signs that the economy is in for a rough stretch. This tends to occur when the economy is in trouble.

Bank of America also expects 12-month forward corporate profit growth expectations to fall by more than 50% from July to December, Hartnett pointed out.

And the rise in the unemployment rate to 4.3% has officially triggered the Sahm Rule, which says that the US economy is in recession when the three-month moving average of the unemployment rate rises at least 0.5% from its low point over the previous 12 months. Recessions have always started before the indicator is officially triggered, Hartnett said.

On top of all of this, Hartnett said that recession risks have been underappreciated, with Bank of America's July Global Fund Manager Survey showing money managers were assigning just 11% chance of a recession in the next 12 months.

Stock market performance has been extraordinary leading up to cuts as well. The S&P 500 was up 32% from the nine months heading into the end of July, while that number has averaged 2% since 1970 heading into rate cuts.

Investors expect the Fed to cut rates for the first time this cycle at its September meeting. But July's lackluster jobs report is prompting some market onlookers to question whether the central bank could issue and emergency cut earlier than that. Markets are now pricing in an 83% chance that rates will be 50 basis points lower after the September meeting, according to CME FedWatch.

"Should the slump in risky assets prices extend significantly further, an emergency cut by the Fed cannot be excluded," said Jean-Louis Nakamura, head of conviction equities at Vontobel, in a memo on Monday.

Like Hartnett, Michael Kantrowitz, the chief investment strategist at Piper Sandler, said last week that he sees stocks to fall alongside rate cuts.

"We expect that we will see a positive correlation between interest rates and stock prices going forward," Kantrowitz said in a note.

Hartnett's comments came as the market plunged into uncertainty on Friday, a mood that carried over into Monday's trading. As of Monday's market close, the S&P 500 was down 8.5% from mid-July. Still, there are plenty of calls for investors to avoid panic as more data comes in.

"Quite frankly, this sell-off is now overdone," said Jim Smigiel, chief investment officer at SEI, in a memo on Monday. "Emergency Fed rate cuts being priced in makes little sense given the economic backdrop in the U.S. and would only serve to destroy policy maker credibility."