Wall Street investment banks are warning of a volatile summer ahead. Investors, it seems, are preparing for the same.
Money is fleeing U.S. equity funds in favour of safer alternatives, while global fund managers are increasingly cautious and resorting to cash reserves. Their cash levels have now reached 5.5 per cent, a level of hoarding generally reserved for crisis situations, according to Merrill Lynch's monthly fund manager survey.
Investors are positioned for a "summer of shocks," Merrill Lynch said in a report. And perhaps rightfully so, according to the bank's chief equity and quantitative strategist, Savita Subramanian.
"An increasing number of charts in our work depict levels that are only prior to a bear market," Ms. Subramanian said, citing such factors as stock buyback trends and declining corporate profits. Goldman Sachs and JP Morgan put out their own notes encouraging reduced exposure to equities.
The silver lining to a cloudy summer, however, could be that bull markets typically end not amid the kind of pessimism currently in abundance, but rather excessive faith in stocks. So any pronounced sell-offs may prove to be buying opportunities for longer-term investors.
After starting the year off with an all-consuming global sell-off, most major markets just as quickly regained composure. The S&P 500 index rose by 16.6 per cent from its mid-February trough to its intraday peak in April. A small portion of those gains have since been given back, including Tuesday's decline that shaved 180 points off the Dow Jones industrial average. For the most part, the prevailing direction over the last month has been sideways.
A quiet May, however, could give way to a "vortex of negative headlines" in June, driving stocks back toward February lows, Ms. Subramanian said in a report last week.
Among the top current anxieties is the next move of the U.S. Federal Reserve, which hiked rates in December for the first time in a decade, signalling "lift-off" from the extraordinarily stimulus brought on by the financial crisis.
Rarely has the Fed gone into tightening mode amid a profits recession. And the few precedents don't offer much comfort regarding the capacity of equities to defy the direction of monetary policy.
"Even if the Fed stays on hold, other markets are tightening," Ms. Subramanian, the Merrill Lynch strategist, said. Just 12 U.S. companies have gone public this year, up to the end of April – the fewest since 2009.
Another ingredient in the mix of risks is the recent deterioration in the Citigroup economic surprise index, according to a JPMorgan note. The most recent stock rally coincided with a rise in the level of surprisingly good economic data. But that indicator has since rolled over.
Goldman Sachs, meanwhile, flagged relatively high U.S. valuations and seasonal weakness in corporate buybacks in June and July as additional reasons to be bearish.
"S&P 500 will likely experience at least one drawdown between now and year-end. We recommend selling upside calls to fund downside protection," David Kostin, chief U.S. strategist at Goldman Sachs, said in a note.
Institutional investors seem to be bracing for such a sell-off, based on the high cash levels found in the Merrill Lynch monthly fund manager survey. Only 12 per cent of the managers surveyed reported taking "higher-than-normal" risk.
Deeply negative sentiment has sparked an exodus out of U.S. equity funds and into the perceived safety of higher-quality bonds and cash. Last week, Merrill Lynch reported the fifth straight week of net equity outflows totalling $44-billion in losses, which is the largest redemption period since August, 2011, after Standard & Poor's downgraded U.S. debt for the first time.
But if the bears are right, and this summer brings about another sell-off, there's a good chance it will be temporary. "Our sell-side indicator suggests sentiment is at bearish extremes, which is bullish for stocks," Ms. Subramanian said.