A Big Tailwind for the Stock Market Has Now Dissipated

Summary: A tailwind for the rally over the past year has been the bearish positioning of investors, with fund managers persistently shunning equities in exchange for holding cash.

Sentiment has turned bullish. Optimism towards the economy has surged to a 2-year high and profit expectations are near a 7-year high. As a result, global allocations to equities rose to a 2-year high in March and "risk appetite" is also at a 2-year high. All of this suggests the big tailwind for equities has now dissipated. The one remaining positive is the high cash balance at funds.

Europe and Japan are now the most overweighted equity markets on a relative basis. Allocations to the US have dropped as the region has underperformed so far in 2017; this is where US equities typically start to outperform again. The weighting towards emerging markets has jumped in the past two months; this is now back to where the last two rallies in that region have started to fade.

Findings in the bond market are still of greatest interest. Inflation expectations are at 13-year highs, a level at which yields have reversed lower in the past. Fund managers' allocations to global bonds fell to a more than 3-year low in March, a level which has often marked a point of capitulation.

For the fourth month in a row, the dollar is considered the most overvalued in the past 11 years. Under similar conditions, the dollar has fallen in value in the month(s) ahead.

Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Cash: Fund managers' cash levels dropped from 5.8% in October 2016 to 4.8% in March. Recall that 5.8% was the highest cash level since November 2001. Cash remained above 5% for almost all of 2016, the longest stretch of elevated cash in the survey's history. Some of the tailwind behind the rally is now gone but cash is still supportive of further gains in equities. A significant further drop in cash in the month ahead, however, would be bearish. Enlarge any image by clicking on it.

Global equities: Fund managers were just +5% overweight equities at their low in February 2016; since 2009, allocations had only been lower in mid-2011 and mid-2012, periods which were notable bottoms for equity prices during this bull market. Allocations in March have jumped to +48% overweight, a 2-year high. This is now well above neutral (0.8 standard deviation above the long-term mean). Outside of 2013, over +50% overweight has historically been bearish (dashed line and shading).

In February 2016, 16% of fund managers expected a weaker economy in the next 12 months, the lowest since December 2011. They are now optimistic: 58% expect a stronger economy in the next year, near a 2-year high. Pessimism explained their prior low allocation to equities and high allocation to cash; that has now flipped.

Similarly, 57% expect better profits in the next year, a 7-year high. This also explains their renewed enthusiasm for equities.

US equities: US exposure had been near an 8 year low during the past year and a half, during which US equities outperformed. US equities had been under-owned. That changed in December, with fund managers becoming +13% overweight, and they remained overweight through February. As we have repeated in recent months, bearish sentiment was no longer a tailwind for US equities, and US equities have since underperformed their global peers. The good news is that fund managers dropped their allocation back to neutral in March: +1% overweight (0.2 standard deviations above its long term mean). This is where US equities typically start to outperform again. Above +20% overweight and sentiment typically becomes a strong headwind (dashed line).

European equities: Fund managers had been excessively overweight European equities in 2015-16, during which time EZ equities underperformed. That changed in July, with the region becoming underweighted for the first time in 3 years. That has dramatically improved to +27% overweight in March, an 11-month high. This is above neutral (0.5 standard deviations above its long-term mean).

Japanese equities: Allocations to Japan had been falling in 2016 after excessive bullishness in 2015. Allocations fell to -8% underweight in September, the lowest since December 2012. Now, allocations have jumped back to +22% overweight. This is 0.6 standard deviations above its long term mean. Bullish sentiment is close to becoming a headwind (dashed line)

Emerging markets equities: In January 2016, allocations to emerging markets fell to their second lowest in the survey's history (-33% underweight). As the region outperformed in 2016, allocations rose to +31% overweight in October, the highest in 3-1/2 years. That made the region a contrarian short. Emerging equities then dropped 10% in the next two months, and allocations fell to -6% underweight in January, making the region a contrarian long again. This month, allocations jumped to +18% overweight (0 standard deviations below/above its long-term mean, i.e., neutral). This is where the last two rallies in emerging markets have started to fade (arrows).

Global bonds: Fund managers are -65% underweight bonds, a fall from -35% underweight in July (which was near a 3-1/2 year high allocation). This is 1.2 standard deviations below its long term mean as well as a more than 3-year low. A capitulation low in the past has often occurred when bonds were -60% underweight (arrows and dashed line). In other words, bonds are now a contrarian long. Note the failure in 2013.

Of note, fund managers' inflation expectations are at the highest level in 13 years. This explains some of the sell off in bonds in the past half year. It's notable that current levels have marked at least a short-term reversal point in yields in the past (lower panel).

Similarly, fund managers' growth expectations are at the highest level since early 2011, at which time yields fell (highlights).

Commodities: Allocations to commodities remain near a 4-year high (+1% overweight). This is 0.3 standard deviations above its long term mean. In comparison, a year ago in February 2016, allocations were near one of the lowest levels in the survey's history (-29% underweight). The improvement in commodity allocations goes together with increased macro optimism.

Sectors: Relative to history, managers are quite overweight equities and very underweight bonds. And for the first time in several months, managers are also more overweight equities than cash and cash weightings have fallen to neutral. The allocation to equities would be even higher if it were not for a large underweighted position in the UK. US equities are marginally overweight relative to history.

Fund managers' risk appetite had been well below the mean during 2016; during the current bull market, risk appetite had only been materially lower in mid-2011 and 2012, relative lows from which equities rose strongly in the following months. That has now changed, with risk appetite at a 23-month high. Risk appetite is the average of fund managers cash, investment horizon and investment risk (e.g., equity allocation and sector weighting).

Dollar: Since 2004, fund managers surveyed by BAML have been very good at determining when the dollar is overvalued. In March 2015, they viewed it as overvalued for the first time since 2009; the dollar index fell from 100 to 93 in the next two months. In late 2015, they again viewed the dollar as overvalued and the index lost 7%. Fund managers have viewed the dollar as overvalued since November 2016 (and in March by the highest amount in 11 years); since then, the dollar has traded marginally lower. Under similar conditions (highlighted in green), the dollar has fallen in value in the month(s) ahead.

Survey parameters are below.

  1. Cash: The typical range is 3.5-5.0%. BAML has a 4.5% contrarian buy level but we consider over 5% to be a better signal. More on this indicator here.
  2. Equities: Over +50% overweight is bearish. A washout low (bullish) is under +15% overweight. More on this indicator here.
  3. Bonds: Global bonds started to underperform in mid-2010, 2011 and 2012 when they reached -20% underweight. -60% underweight is often a bearish extreme.
  4. Commodities: Higher commodity exposure goes in hand with improved sentiment towards global macro and especially EM equities.

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