Are Investors Too Bullish for Their Own Good?

Bulls and Bears

The new year is bringing more optimism to Wall Street as investors are feeling better about global growth prospects. This is especially true for the United States and Europe. As a result, they also feel better about equity returns, but are investors getting ahead of themselves?

The proportion of investors who say the global economy will strengthen this year increased to a net 75 percent in January from a net 71 percent in December, according to a new survey from Bank of America Merrill Lynch, which polls fund mangers that have an overall total of $653 billion of assets under management. A net 48 percent expect corporate profits to climb higher. Both the U.S. and Japan are the most favorable prospects for profits. However, sentiment about Europe also improved significantly month-over-month.

“Managers are positioned for a strong profit recovery in Europe, and the upcoming earnings season is key to maintaining this stance; given the high sentiment, any earnings disappointment will likely be punished by investors,” said John Bilton, European investment strategist.

With growth convictions on the rise, investors are quite bullish on equities. A net 55 percent of respondents say they are overweight equities, representing a sharp turnaround from mid-2012 when a net 4 percent were underweight equities. Interestingly, a net 7 percent believe equity markets are overvalued, the highest reading since 2000. The overvaluation view is driven mostly by the views on U.S. equities, where a net 72 percent say stocks are overvalued.

In 2013, all three major U.S. indices posted a record year. The Dow Jones Industrial Average jumped 26.5 percent to post its best year since 1995, while the S&P 500 surged nearly 30 percent to log its biggest annual gain since 1997. Meanwhile, the Nasdaq gained 38 percent to return to levels not seen since the dotcom bubble.

Europe equities are a favorite among fund managers. A net 22 percent believe companies in the region are undervalued compared to a net 15 percent last month. On a 12-month view, when asked which equities they would most like to overweight, managers picked Europe with a net 34 percent, the second-highest reading in the history of the survey. A hard landing in China and a collapse in commodity prices are seen as the biggest tail risks going forward.

On the downside, risk taking capacity is also on the rise. A net 4 percent of managers say they are undertaking a higher-than-normal level of risk in their portfolios, a near-record high. A net 32 percent of respondents say they are underweight staples, the lowest in a decade. Staples are typically considered as a defensive sector. In comparison, a net 42 percent are overweight tech stocks. Other favorite sectors include industrials and financials.

While some market participants expect a sharp correction in the stock market this year, high cash levels could ease any declines. “Until corporations reduce high cash levels, investors will run high cash levels and equity corrections will be extremely limited,” explains Michael Hartnett, chief investment strategist at BofA Merrill Lynch Global Research.

Instead of using cash on capital expenditures, companies have been repurchasing stock and raising dividends — two activities typically seen to help stabilize equity prices. It’s important to note that corporations also have debt on their balance sheets, so cash levels are not as high as they appear.

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