One of my favourite market sentiment indicators is the monthly survey of global fund managers by Bank of America (BofA). It asks the people who are responsible for a big chunk of the money flows in the market (which dictates price in the short term at least) where they're actually putting their money.
When they're gloomy and worried, it's often a good sign that the markets are about to go up; when they're excited and optimistic, it's often a good sign that the market is heading for a fall.
This month? Well, let's be blunt – it's looking toppy out there.
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There's not much money left to put into the markets
The attitude of global fund managers towards the market is a good contrarian indicator. To be clear, this is not because these people are stupid (or any more stupid than you or me, at least), it's because collectively, they are the market (in a stylised way at least). If they are very bullish and they have put all the money into the market, it means there are no buyers left. And if there are no buyers left, then prices simply have to fall. Same for when they're ultra-gloomy – if there are no sellers left, prices will rise.
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So where are we now? There might be some buyers left, but if there are, they're an endangered species. The survey has been running since the late 1990s. Fund managers have never been this bullish about global economic growth. You can understand that – we're rebounding from the pandemic – but it's still unnerving to see such a consensus.
Noteworthy, too, given the coalescing consensus around the “commodities supercycle” theme, allocations to equities and commodities are the highest since 2011 (which is the last time both delivered negative returns). Meanwhile, record levels of investors say they are taking on higher risk than normal.
But the most important thing is that cash levels – at 3.8% – are at their lowest in eight years, since just before the “taper tantrum” of March 2013. In other words, there's just not that much money “sitting on the sidelines” ready to join the party. That adds up to a market which is pricing in a very bright outlook. That means it won't necessarily take a huge surprise to get everyone panicking.
Now, to be clear, you shouldn't change your plans in the face of a signal like this. Yes, there's no doubt that the market is getting overheated. The problem is that you never know how much more overheated it might get. Meanwhile, there are areas which are undeniably appealing, particularly if you agree that interest rates are likely to remain low and that inflation is likely to take off.
So stick to your plan. Really, I just tell you this stuff so that you don't panic if anything scary, like a big drop in the market, does happen.
What could trigger a proper correction from here?
That said, what could tip the balance here? At the risk of over-simplifying, the reason the market is going up is because investors are pricing in what I think of as a “perfect reflation”. This has four components.
One: vaccines will work and the economy will bounce back. Two: austerity is dead – in the US, Joe Biden will spend lots of money while other governments won't be too quick to raise taxes or cut spending. Three: financial repression is here – central banks will make sure interest rates stay low because they can't allow the cost of servicing all that debt to rise. Four: we'll get Goldilocks inflation – not too high, not too low, but “just right”.
Nothing to upset the apple cart, in other words. It's a nice story, and you can see why investors might be keen to buy off the back of it. So what are the risks to this rosy outlook?
First: the economy disappoints. That could happen if there's a resurgence of Covid or vaccines suddenly disappoint. That seems like an outlier to me.
Second: stimulus disappoints. Governments look down from atop the debt mountain and panic. No one says “austerity”, but they do rein in the more ambitious spending efforts. Again, this seems unlikely. The political mood music is mostly in favour of more spending and it's hard to see why politicians would make their lives more difficult given the choice.
Third: central banks drop too many hawkish hints. This is a possibility. Indeed, I suspect that the next jolt lower will be triggered by a central bank looking a bit more aggressive than it means to. But in the longer run, I think central banks will fall over themselves to prove to markets that they don't care about inflation. Also, they'll have the “taper tantrum” in mind. Remember that Janet Yellen faced a similar juggling act when she started raising interest rates. They know what to do here.
Fourth: inflation might take off faster and farther than anyone believes possible right now. I have to say, my money's on this one. And this is the bit that'll make central banks lives a lot trickier. Because the higher inflation goes, the stronger their protestations and the more aggressive their money printing will have to come.
Make no bones about it, the market will force the issue. It won't be bond vigilantes we have to worry about, so much as investors playing chicken with the Federal Reserve. They'll push rates up until the Fed is forced to introduce yield curve control or something similar. What will that take? Hmm – probably a solid correction in the S&P 500 if recent history is any guide, though your guess is as good as mine.
One thing is clear: the market is in a vulnerable position, and it's also starting to notice rising interest rates. US Treasury yields have climbed sharply. The Nasdaq – the main home to the most interest-rate sensitive stocks in the US – is having difficulty pushing to new highs. Gold – which doesn't appreciate rising real rates (ie higher interest rates after taking inflation into account) isn't too happy either.
Push will come to shove. I suspect the correction, when it comes, will be driven by rising rates – “taper tantrum” style – and investors won't relax until the Fed is forced to take explicit action to deal with it.
Anyway, let's sit back and see. Meanwhile, the UK looks a decent bet as it has a lot of banks (they like higher interest rates) and energy stocks (energy prices are rising anyway and the sector still isn't popular).
We'll have more on inflation prospects in the next issue of MoneyWeek, out on Friday. Get your first six issues free here.
