BofAML: 'Uncertainty shock' from election endangering stock market

As major averages continue to scale new highs, one Wall Street firm believes the stock market rally is getting overdone.

Bank of America Merrill Lynch strategists are warning of "an elevated risk of correction," which implies that the market could be in for a decline of 10 percent or more. The warning, in a report for clients Tuesday, comes as stocks were again in rally mode , pushing the Nasdaq composite (NASDAQ: .IXIC) to a record and putting other indexes a whisker away from establishing fresh peaks.

Amid the risk-on market structure, BofAML found at least 10 trouble spots that could slow down the market's momentum. Among them: the looming presidential election , which Wall Street expects Hillary Clinton to win, though the outcome is far from settled.

Despite a cascade of bad headlines and missteps, Republican Donald Trump remains strongly in contention . In a four-way race, Trump trails Clinton by just 4.3 points, according to the latest Real Clear Politics polling average.

"This year's presidential election could come with an uncertainty shock and a slowdown in business investment," the BofAML team led by equity and quant strategist Savita Subramanian wrote.

The note mentions neither Trump nor Clinton by name, nor does it specify which outcome would surprise. However, several surveys have shown upward of 70 percent of Wall Street executives expecting Clinton to win the presidency.

Policy uncertainty and a rise in volatility usually go hand in hand as elections approach, Subramanian said. That's an especially important trend considering how complacent the market has become. The CBOE Volatility Index (INDEX: .VIX), a popular gauge of investor anxiety, remains moored below 12 — its historical average is closer to 20 — and is down 35 percent for the year.

Though the firm is long-term bullish about the market, Subramanian has been warning since at least May that there's near-term danger. BofAML has a full-year price target of 2,000 for the S&P 500 (INDEX: .SPX), implying a net 8 percent or so decline from current levels by the time 2016 closes.

Among the other concerns: Expensive valuation, overly bullish positioning and high expectations for fiscal stimulus. Both candidates have said they plan on spending heavily to improve the nation's infrastructure and create high-paying jobs, but the note cautions that investor hopes for spending "appear ripe for disappointment."

The firm also sees headwinds from waning surprises in the economic data, weak sales growth, a slowdown in China, high levels of leverage and tightening credit conditions, and September's status as the market's weakest month historically.

Investors also should fear the Fed , the firm said. Investors are pricing in at most one rate hike in 2016 and nothing else well into 2017. BofAML envisions "a far more aggressive pace of Fed tightening than is currently priced into the market."

The firm's forecast sees a funds rate of about 1.75 percent by the end of 2018; current fed funds futures contracts indicate a rate of just 0.77 percent by then. The Fed currently targets the rate at 0.25 percent to 0.5 percent, with the actual rate holding at 0.4 percent.