Fund Managers' Current Asset Allocation - August

Summary: Overall, fund managers' asset allocations in August provide conflicting views on sentiment.

On the one hand, fund managers' cash remains at the highest levels since the 2011 and 2012 equity lows and the panic in 2008-09. This is normally contrarian bullish.

However, allocations to equities rose over the past two months and are above the mean. Cash levels are high because fund managers are underweight emerging markets, US equities, commodities and bonds. In August, their exposure to European and Japanese equities increased.

Moreover, fund managers remain very overweight "risk on" sectors: allocations to discretionary, banks and technology are well over their means. Allocations to defensive sectors, like staples, are near all-time lows.

Net, this is not the sentiment profile of investors who are fearful.

Regionally, allocations to the US and emerging markets are at very low levels from which they normally outperform on a relative basis. The dollar is also considered highly overvalued, and BAML fund managers have been prescient in the past in calling turning points in the dollar.

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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.

To this end, fund managers became very bullish in July, September, November and December 2014, and stocks have subsequently sold off each time. Contrariwise, there were some relative bearish extremes reached in August and October 2014 to set up new rallies. We did a recap of this pattern in December (post).

Let's review the highlights from the past month.

Fund managers cash levels remained over 5% for a second month, the first time it's been this high for two months in a row since early 2009. This is an extreme and it's normally very bullish for equities (green shading). Note that cash levels haven't been much below 4.5% since early 2013.  

How Asset Classes Have Responded To The First Rate Hike

Summary: How have different asset classes in the past responded when the FOMC has raised rates for the first time? Commodities were the best performing asset; they boomed.  The dollar sold off. Equities usually rallied into the decision, then sold off, and then rallied again. Treasury yields rose. The total return for high yield bonds was usually positive.

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On September 17, the FOMC will meet. And expectations are that the Fed will enact a 25bp rise in rates. This would be the first change in rates since December 2008, and the first rise in rates since June 2006 (here).

The question for investors is: how might various assets classes react? To answer, we can look at how they have reacted in the past.

Before looking at the data, consider this: a rate increase means that the economy is improving enough that employment and inflation are considered to be well on the path to being healthy. You would expect, therefore, that stocks would do well if the Fed felt comfortable raising rates. An improving economy also implies demand for commodities and lower default rates, meaning that commodity prices are rising and high yield bonds are at least stable.

And in fact, this is what usually happens when the Fed raises rates for the first time: stocks and commodities rise and high yield bonds have a positive return over the next year (the average length of time rates rose). The chart below covers the period after the first rate hikes in 1983, 1986, 1988, 1994, 1999 and 2004 (data from Allianz).

Weekly Market Summary

Summary: Price action in US equities is weak. Two potential opportunities to kick off a rally failed this week. Despite this, short term sentiment and seasonality support a move to the upper end of the range. Ultimately, lower lows are still ahead over the coming weeks.

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US equities had two opportunities to kick off a rally this week. Neither had much follow through.

On Monday, positive breadth was 89%; days like these typically indicate strong buying interest among big investors and thus the initiation of a rally. The most recent ones were in October and December 2014 and January and February 2015, and equities rose higher each time. This one failed the next day, giving back all the gains. The last time this happened, at a low, was in the turbulent summer of 2011.

Why High Yield And Equity Markets Have Diverged

Summary: The apparent divergence between credit-risk, as seen in rising high-yield bond spreads, and equities is due primarily to the 60% drop in oil prices over the past year. There's been no remarkable rise in spreads outside of energy; these are back to being in-line with the long term mean after falling to a 7-year low in 2014. If commodity prices continue to fall, this will be a meaningful metric to watch for equity risk.

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Spreads on high yield (junk) bonds relative to treasuries have widened. This implies heightened credit risk. The widening and narrowing of spreads is correlated to equity performance over time. Since mid -2014, these have diverged (data from Gavekal Capital).

There's No Carnage Under The Surface of the Indices

Summary: Some stocks are doing well, and some are doing less well. On average, stocks are higher over the past year and are not far off their 52-week highs. This comes after the average stock has risen 80-100% over the past 3 years. There's no widespread carnage being hidden by the indices during the current period of sideways trading.

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Over the past year, the S&P index is up 7%, the Nasdaq 100 is up 14% and the Russell 2000 is up 6%. Since the start of 2015, those gains are 1%, 7% and 0%, respectively.

With a choppy trading range so far in 2015, are the indices hiding widespread carnage under the surface? In other words, have most stocks fallen hard and their losses hidden by a few winners? The short answer is no.

To be clear, some sectors have been hard hit. From their highs, energy companies have fallen an average of 25%. Material stocks have fallen an average of 15%. And clearly small cap companies in the Russell have been much harder hit than large cap stocks in the other indices.

But other stocks have gained, especially in the healthcare, consumer discretionary and financial sectors. So how have stocks performed on average?

Most stock indices are weighted by market capitalization, so larger companies have a disproportionate influence on the index's gains and losses. By looking at equal-weighted indices, in which every company has the same influence, we can see how an average stock has performed.

Starting with the S&P, the average stock is up 6% in the past year and flat for 2015. Since their 52-week high, the average stock is down just 3%. Keep in mind, the average stock in the S&P has risen 80% in the past 3 years.