Sentiment extremely bearish; three reasons why stocks are falling

Investors are extremely bearish, with the start of 2016 shaping out to be the worst ever for many stock markets around the world.

The Bank of America Merrill Lynch bear/bull indicator has fallen into extremely bearish territory again, with five of its six components either bearish or very bearish, and just hedge fund positioning in neutral territory.

Long-only positioning, credit market technicals and equity flows were all bearish, while equity market breadth and bond flow were very bearish.

Sentiment is extremely bearish but there are good reasons for that. Source: Bank of America Merrill Lynch

Sentiment is extremely bearish but there are good reasons for that. Source: Bank of America Merrill Lynch

The bear/bull indicator may be sending a contrarian “buy” signal at this depressed level, but the analysts at Bank of America Merrill Lynch recommend being long cash and volatility.

They say the risks of short, sharp pullbacks in risk assets are high, “at least until PMIs are back over 50 in China and the US, two-way risk emerges in the Chinese yuan and oil, and/or a spike in volatility induces the Fed to pause.”

There is a risk that the S&P 500, which has lost nearly 5% in the first week of trading of the year, pulls back to between 1850 and 1900, according to the analysts’ report.

They note that in 2015 cash outperformed both stocks and bonds for the first time since 1990 and that “ever since the end of QE3 in late 2014, leadership across asset markets has shifted sharply away from stocks and bonds to the US dollar, volatility and cash.”

“We believe the three drivers of asset prices — Positioning, Profits, Policy — argue for further outperformance of defensive assets in the near-term.”

They list three trends that point towards decreased demand for risk assets in the first quarter: The first is that private clients are moving into cash (allocations to cash jumped to a two-year high of 12% of assets under management in December, while equity allocations were 59% from the record 63% in March 2015).

The second is that sovereign wealth funds, an important supplier of capital flows for equities and other assets, have stopped pumping fresh money into the capital markets. The level of sovereign wealth funds assets under management has stagnated at $7.2 trillion in recent quarters, and of those, $4.4 trillion belongs to countries that are commodity producers.

And finally, the third headwind for risk assets is that, with interest rates and bond yields rising, however slowly, the cost of issuing debt is increasing and stock buybacks will be less of a tailwind for equities than they were.

“If companies cannot now issue debt to fund buybacks, this marks an important turning point for the stock market,” the analysts at Bank of America Merrill Lynch point out.

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