by Urban Carmel, The Fat Pitch
Summary: Global equities have risen 18% so far in 2017 and yet, until this month, fund managers have held significant amounts of cash and been, at best, only modestly bullish on equities. All of this has suggested lingering risk aversion.
That has now changed. Cash levels have fallen to the lowest level in 4 years. Allocations to global equities have risen to the highest level in 2-1/2 years. In most respects, investors are now bullish.
In the past 6 months, US equities have outperformed Europe by 10% and the rest the world by 3%. Despite this, fund managers remain underweight. US equities should outperform their global peers.
Fund managers are underweight global bonds, nearly to an extreme that has often marked a capitulation low in the past. Only 5% of fund managers believe global rates will be lower next year, a level at which yields have often fallen.
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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.
Overall: Relative to history, fund managers are overweight equities and underweight bonds. Cash is now neutral. Enlarge any image by clicking on it.
Within equities, the US is significantly underweight while Europe, Japan and emerging markets are significantly overweight.
A pure contrarian would overweight US equities relative to Europe, Japan and emerging markets, and overweight global bonds relative to a 60-30-10 basket.
Cash: Cash is now neutral at 4.4% (BAML considers cash levels above 4.5% to be a contrarian long for equities). Cash had been a consistent tailwind for equities until this month. A recap:
Fund managers' cash levels rose to 5.8% in October 2016, the highest cash level since November 2001. This set up a contrarian long in equities.
Cash remained above 5% for almost all of 2016 and into early 2017, the longest stretch of elevated cash in the survey's history. Cash remained near 5% until October 2017.
In November, cash fell to 4.4%, the lowest level since October 2013. At current cash levels, a tailwind behind the rally is gone. A further drop in cash in the month(s) ahead would be decisively bearish.
A composite measure of risk (based on allocations to cash, higher risk assets and investment horizon) remains neutral despite the long rally in equities.
Global equities: After a 21 month rally, global equity allocations are finally near a relative bullish extreme. This is now becoming a headwind to further gains. A recap:
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 November increased to +49% overweight, which is well above above neutral (+0.8 standard deviations above the long term mean), and the highest level since April 2015: this is a headwind to further gains.
Outside of 2013-14, over +50% overweight has historically been bearish (dashed line and shading).
In February 2016, more than 20% of fund managers believed profits would be weaker in the next 12 months, the lowest since 2012. They are now more optimistic, but not exceptionally so: 41% expect stronger profits in the next year (red line). Pessimism explained their prior low allocation to equities and high allocation to cash; that has changed a bit.
Similarly, more (but only a net 36%) expect a better economy in the next year. This explains their enthusiasm for equities but, like cash levels, investors are still not excessively bullish.
US equities: US equities remain strongly out of favor and should outperform. A recap:
Fund managers were consistently and considerably underweight US equities for a year and a half starting in early 2015, during which US equities outperformed.
That changed in December 2016, with fund managers becoming +13% overweight, and they remained overweight through February 2017: bearish sentiment was no longer a tailwind for US equities and US equities underperformed their global peers.
Fund managers have since dramatically dropped their allocation to the US. In September, they were -28% underweight, the lowest since November 2007. That rose to -16% underweight in November (-0.6 standard deviations below its long term mean). US equities should outperform.
Notably, the S&P has outperformed the Europe's STOXX600 by 10% the past six months.
Above +20% overweight and sentiment typically becomes a strong headwind (dashed line).
Fund managers' positioning in US equities versus Europe is among the lowest in the past 10 years (-1.0 standard deviations below its long term mean), a condition under which the US typically outperforms.
European equities: European equities are at high risk of underperforming. A recap:
Fund managers had been excessively overweight European equities in 2015-16, during which time European equities underperformed.
That changed in July 2016, with the region becoming underweighted for the first time in 3 years. The region then began to outperform.
European exposure is +47% overweight in November. This is well above neutral (+1.2 standard deviations above its long term mean). European equities are at high risk of underperforming.
Emerging markets equities: Emerging market equities are at risk of underperforming. A recap:
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.
Allocations fell to -6% underweight in January 2017, making the region a contrarian long again: the region has since outperformed.
This month, allocations were +43% overweight, near a 7-year high (+1.2 standard deviations above its long term mean). Emerging market equities are at risk of underperforming.
Global bonds: Bonds are nearing a strong contrarian long. A recap:
In July 2016, global bond allocations rose to -35% underweight, nearly a 3-1/2 year high. Bonds subsequently underperformed a 60-30-10 basket.
A capitulation low in the past has often occurred when bonds were -60% underweight, a level reached in March and April (shading and dashed line). In other words, bonds became a contrarian long.
In September, fund managers' allocations to bonds rose -48% underweight bonds, the highest in 10 months (-0.3 standard deviations below its long term mean, i.e., close to neutral). Bonds have since underperformed.
Now in November, allocations to bonds dropped back to -56% underweight (-0.7 standard deviations below its long term mean). This is again approaching a capitulation low.
Fund managers' growth expectations relative to inflation are the highest on record (blue line). Similar (but lower) peaks in 2Q 2010, 1Q 2011, 2Q 2014 and 2Q 2015 preceded a fall in yields (second chart).
Similarly, only 5% of fund managers believe global rates will be lower in the next year; 77% think rates will be higher. This, too, has most often coincided with lower yields (second chart).
Survey parameters are below.
- 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.
- Equities: Over +50% overweight is bearish. A washout low (bullish) is under +15% overweight. More on this indicator here.
- Bonds: Global bonds started to underperform in mid-2010, 2011 and 2012 when they reached -20% underweight. -60% underweight is often a bearish extreme.
- Commodities: Higher commodity exposure goes in hand with improved sentiment towards global macro.
