How a delayed trickle effect from the WeWork blowup could end up hitting the S&P 500

Problems in the IPO market have the potential to ripple through and slam the S&P 500, and the failed WeWork offering could be a warning, according to Bank of America Merrill Lynch equity analysts.

That’s because private equity, heavily invested in start-ups, has become a much bigger piece of the investment portfolios of asset allocators, like pension funds. If private equity runs into trouble, pension funds would struggle to unload holdings and could instead sell the easiest assets to dispose of — including the S&P 500.

“Faint cracks are showing in the IPO market vis a vis WeWork’s recent aborted IPO. We are concerned that if private equity assets are marked down, pension funds may be forced sellers of the most liquid assets, which primarily reside in passive exposure to the S&P 500,” the BofA analysts wrote in a note.

WeWork was to have been one of the most high-profile IPOs of the year, but within a month of its August filing, its initial public offering was shelved, its CEO was ousted, and its valuation collapsed from near $50 billion. It’s since been taken over by its largest investor, SoftBank.

Nonetheless, the BofA analysts remain somewhat bullish for 2020, with a target of 3,300 on the S&P 500.

“We’re looking for upside. We’ve seen enough pent up cap ex which could be unleashed next year,” said Savita Subramanian, chief quant and equity strategist at BofA. But the year could start off on a rocky footing.

“I do think come Jan. 2, there will be a shakeout,” she said, adding investors should be looking at areas of value, like financials and select industrial companies.

Subramanian, appearing on CNBC’s “Squawk Box,” said one of her concerns is that private equity has become highly valued, and in some cases more so than public equity. The environment for private equity is “super-conducive.”

At the same time, pension funds have increased their exposure to illiquid investments, including private equity.

“25% of pension funds are in illiquid assets. That’s not the whole kit and caboodle,” said Subramanian. But they have not been tested in a time of stress or when capital costs are rising. That number had been 8% in 2006.

Asset allocators have also shifted more funds into fast-money type investments, like quants and hedge funds.

“Of those active institutional investors that remain, the overlap in their single stock holdings is at extreme levels–mostly in momentum stocks,” the BofA analysts wrote. “Momentum has driven the S&P 500 to become very tail heavy, with the 10 largest companies now representing roughly 25% of the index, similar to what we saw during record Tech Bubble levels.”