A recent Bank of America survey reveals that professional money managers are displaying their highest level of optimism toward the stock market in years. While this might appear to be a positive sign, it could also be a harbinger of caution, as the bank’s proprietary "Bull & Bear Indicator" is now just a tenth of a point shy of issuing a "sell signal." This heightened bullishness among investors, marked by historically low cash reserves and elevated profit forecasts, suggests a market ripe for potential correction.
The core philosophy behind Bank of America’s indicator is that market trends are shaped by three key factors: investor positioning, corporate profitability, and monetary policy. The most opportune moment to acquire risky assets is typically when investor sentiment is predominantly bearish, profit outlooks are recessionary, and policymakers are actively stimulating the economy. Conversely, the ideal time to divest is when investors are overwhelmingly bullish, profit expectations are soaring, and policy measures are tightening. Currently, the market exhibits characteristics aligned with the latter scenario, indicating a potential inflection point for investors.
As of the recent survey, investor positioning is markedly bullish, with fund managers’ cash holdings dropping to a record-low 3.3%. This reflects a significant appetite for risk, with investors allocating substantial portions of their portfolios to stocks and commodities, reaching levels not seen since early 2022. This aggressive stance underscores the current widespread confidence in market growth.
Optimism regarding corporate earnings is also at a peak. Nearly two-thirds of the fund managers surveyed anticipate an increase in global earnings over the next year, representing the largest proportion since August 2021. This contrasts sharply with the mere 3% of respondents who foresee a global economic recession in the coming year, highlighting a strong belief in continued economic expansion.
In terms of monetary policy, the current landscape appears less restrictive. The Federal Reserve recently implemented its third interest rate cut of the year, aiming to bolster a softening labor market despite persistent inflation above its 2% target. Additionally, upcoming labor market data and a new tax bill are expected to further stimulate economic activity, potentially reinforcing arguments for continued rate reductions and contributing to a favorable market environment.
Historically, the Bull & Bear Indicator has issued a "sell" signal 16 times since 2002. While the S&P 500 has often seen gains in the three months following these signals, the average three-month return during these periods has been a negative 1.4%, with pullbacks generally exceeding advances. This suggests that while a "sell signal" doesn't guarantee an immediate downturn, it often precedes periods of increased market fragility.
The indicator triggered two "sell" signals earlier this year, in July and October. Both instances preceded periods of significant market volatility, yet neither resulted in a prolonged market slump. Following the July signal, the S&P 500 climbed 7.5% over three months. Since the October warning, the index has advanced approximately 1%, demonstrating that market reactions to these signals can vary and are not always indicative of an immediate, sustained decline.
While the overall market sentiment appears exuberant, some other indicators offer a more nuanced view. CNN’s Fear & Greed index recently registered in a neutral zone, less bearish than previous weeks, suggesting a balanced outlook among a segment of investors. Similarly, the weekly AAII survey of individual investor sentiment has shown a shift towards bullish or neutral readings, recovering from earlier pessimism. The VIX, often referred to as Wall Street’s "fear gauge," continues to indicate market calm, implying that despite the rising bullishness, extreme fear has not yet dissipated entirely.
Despite the prevailing optimism, investors are increasingly expressing reservations about the artificial intelligence (AI) trade that has largely fueled the bull market over the past three years. Nearly 40% of investors identified an AI bubble as the most significant risk facing markets in the upcoming year. A further 20% expressed concern over a "disorderly rise in bond yields," highlighting a growing awareness of potential vulnerabilities.
A notable shift in investor concern is the emergence of AI spending as a potential destabilizing factor for debt markets. When asked about the most probable cause of distress in credit markets, nearly 30% of respondents pointed to "AI hyperscaler capex," making it the second most frequent response. This marks the first time that AI-related expenditure has been flagged as a material risk to debt markets, reflecting evolving market perceptions.
Concerns surrounding the substantial AI infrastructure investments by major technology companies have already begun to exert downward pressure on tech stocks in recent months. The Roundhill Magnificent Seven ETF (MAGS) has seen a decline of approximately 4% since its peak in late October. Individual AI-darling stocks like Nvidia (NVDA) and Oracle (ORCL) are currently trading significantly below their all-time highs, down about 15% and 40% respectively. This suggests that the initial exuberance around AI may be tempering as investors grapple with the financial implications of large-scale AI deployment.