Record numbers of fund managers now see equities as being overvalued, a closely watched piece of research shows, but it appears that signs of ‘irrational exuberance’ are largely missing from markets. 
The June edition of the Bank of America Merrill Lynch Global Fund Manager Survey found that there has been a jump in the number of asset allocators across the globe who think equities are overvalued.
Bank of America Merrill Lynch (BofA ML) polled 180 participants with combined assets under management of $513bn (£402bn), with the survey being carried out between 2 and 8 June 2017.
As the chart below shows, equities have enjoyed a strong run in recent years. The S&P 500 has led the pack over five years with total return of close to 140 per cent, while the Euro Stoxx index has gained 125 per cent and the FTSE All Share is up 71.59 per cent.
Performance of indices over 5yrs
Source: FE Analytics
Respondents to the Bank of America Merrill Lynch Global Fund Manager Survey highlight US stocks as being the most overvalued. When it comes to individual sectors, three-quarters went for internet stocks – with 57 per cent saying they were expensive and 18 per cent warning they are bubble-like.
Over the following pages we look at a selection of charts showing how many fund managers view stocks as expensive, the amount of cash they’re sitting on, the level of protection they’ve taken over and what contrarians should consider buying and selling.
High equity valuations need rising profits
Source: Bank of America Merrill Lynch Global Fund Manager Survey
Some 44 per cent of global asset allocators now believe that equities are overvalued. This is up from 37 per cent in June’s survey and is highest response that BofA ML has on record. These concerns over excess valuation have come at a time when fund managers have high global profit expectations. The bank’s analysts say this suggests market vulnerability to profit weakness is “very high”. The allocation to stocks did fall in June, down to a net 40 per cent overweight, but this is still 0.5 standard deviations above the long-term average.
Global FMS average cash balance (%)
Source: Bank of America Merrill Lynch Global Fund Manager Survey
BofA ML’s Fund Manager Survey Cash Rule states that an average cash balance among portfolios of 4.5 per cent is considered a contrarian buy signal for equities, whereas a cash balance of below 3.5 per cent is a contrarian sell signal. In June, the average cash balance hit 5 per cent – up from 4.9 per cent in the previous month’s survey and moving further into ‘buy’ territory. But BofA ML’s Research Investment Committee has been adding to cash: “The solid gains in both stocks and bonds call for a more measured investment stance, as we believe the risks of a correction are rising. Last month we raised our allocation to cash to 4 per cent from 2 per cent in our moderate risk profile.”
It ain't irrational yet
Source: Bank of America Merrill Lynch Global Fund Manager Survey
Putting to the two previous charts together and the analysts behind the Bank of America Merrill Lynch Global Fund Manager Survey suggest there is little sign of “irrational exuberance” being seen in markets. This is because concerns over excess valuations have come at a time when cash shored up rather than put to work. BofA ML’s Research Investment Committee said that earnings seem to justify higher stock prices: “Strategist Nigel Tupper notes that the Global Earnings Revision Ratio (ratio of earnings upgrades to downgrades) further strengthened in May to 1.05, dominated by the US and Europe (at a nine-year high), and broad improvement across most sectors in the world. Global equity markets tend to rally when the ratio is above 1.0. Tupper's Global Wave indicator, a composite of seven economic, fundamental and sentiment measures, has improved for 12 consecutive months. Previous upturns have averaged two years, and peaks in the indicator are usually accompanied by coordinated monetary tightening, certainly not the conditions we have today.”
Protection against a sharp fall in equity markets in the next 3 months
Source: Bank of America Merrill Lynch Global Fund Manager Survey
The suggestion that fund managers across the globe have an eye on high valuations but are not overly worried that a large-scale correction is looming is supported by the number taking out hedges against a sharp sell-off in equity market. In June, 39 per cent of respondents told BofA ML that they have not bought equity hedges – an increase of 8 percentage points on the previous month’s survey.
What do you consider the biggest ‘tail risk’?
Source: Bank of America Merrill Lynch Global Fund Manager Survey
Asset allocators are not blind to the risks present in the market, however. When asked what they consider to be the biggest tail risk in markets, 31 per cent of respondents cited Chinese credit tightening. BofA ML’s Research Investment Committee said: “The People's Bank of China (PBOC) is tightening monetary conditions in an effort to reduce leverage in its financial sector. China economist Helen Qiao expects one or two more quarters of tightening before monetary policy returns to a more neutral stance. Qiao expects GDP growth to slow modestly to 6.5 per cent in the second half from the 6.9 per cent pace in the first quarter. One risk is the PBOC overdoes the tightening, resulting in slower growth than expected. However, the PBOC values stability over everything else, limiting the chances of that happening, according to Qiao.” Another 18 per cent said a crash in global bond markets is the biggest tail risk while 14 per cent pointed to a delay in US corporate tax reforms.
In which region are equities most over- and under-valued?
Source: Bank of America Merrill Lynch Global Fund Manager Survey
The June survey found that a net 84 per cent of investors think US is the most overvalued region, which is a new all-time high. Meanwhile, a net 18 per cent regard European equities as undervalued and a net 48 per cent think emerging market equities remain undervalued. BofA ML’s Research Investment Committee added: “As we recommended last month, it may be prudent for investors to raise allocations to cash as market risks seem to be rising. We recommend a 4 per cent allocation to cash for the moderate risk profile. We continue to see opportunities in equity markets outside the US. Japanese stocks should benefit from faster EPS growth due to a weaker yen and improved economic growth, as well as having some of the cheapest valuations in developed markets. European ex-UK equities remain attractive, as European equity strategist James Barty expects earnings growth in Europe to be 15 per cent in 2017 compared to 9 per cent for the US. Valuations of European stocks look attractive vs the US on an absolute and relative basis. Despite the risk of a slowing China, emerging market stocks, which have reasonable valuations, are benefiting from improving global growth and a weaker dollar.”
The longs & shorts relative to Global Fund Manager Survey history
Source: Bank of America Merrill Lynch Global Fund Manager Survey
The above chart shows the current positioning of asset allocators relative to long-term history. As can be seen, the longest positions are in eurozone stocks, banks and the euro while the biggest underweight are to sterling, energy and UK stocks. BofA ML’s analysts said this means the contrarian macro bear – or those expecting weaker growth – should sell banks and eurozone stocks to buy bonds and healthcare. Conversely, the contrarian macro bull expecting higher inflation would sell discretionary and tech stocks while buying the UK and energy.