Summary: A tailwind for the rally since February 2016 has been the bearish positioning of investors, with fund managers persistently shunning equities in exchange for holding cash.

Fund managers have become more bullish, but not excessively so. Profit expectations are near a 7-year high and global economic growth expectations are near a 2-year high. However, cash balances at funds also remains high, suggesting lingering doubts and fears.

Of note is that allocations to US equities dropped to their lowest level in 9 years in April and remain equally low in May: this is when US equities typically start to outperform. In contrast, weighting towards Europe and emerging markets have jumped to levels that strongly suggest these regions are likely to underperform.

Fund managers remain stubbornly underweight global bonds due to heightened growth and inflation expectations. Current allocations have often marked a point of capitulation where yields reverse lower and bonds outperform equities.

For the sixth month in a row, the dollar is considered the most overvalued in the past 11 years. Under similar conditions, the dollar has fallen in value in the month(s) ahead.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014.

Let's review the highlights from the past month.

Global equities: Fund managers were just +5% overweight equities at their low in February 2016; since 2009, allocations had only been lower in mid-2011 and mid-2012, periods which were notable bottoms for equity prices during this bull market. Allocations in May have increased to +45% overweight, which is above neutral (0.7 standard deviations above the long term mean). Outside of 2013-14, over +50% overweight has historically been bearish (dashed line and shading). This is getting close to being a headwind to further gains.

In February 2016, more than 20% of fund managers believed profits would be weaker in the next 12 months, the lowest since 2012. They are now optimistic: 56% expect stronger profits in the next year, near a 7-year high. Pessimism explained their prior low allocation to equities and high allocation to cash; that has now changed.

US equities: Fund managers were consistently and considerably underweight US equities for a year and a half starting in early 2015, during which US equities outperformed. That changed in December 2016, with fund managers becoming +13% overweight, and they remained overweight through February: bearish sentiment was no longer a tailwind for US equities and US equities underperformed their global peers. Fund managers have now dramatically dropped their allocation to -17% underweight, near the lowest since January 2008 (0.7 standard deviations below its long term mean). This is where US equities typically start to outperform again. Above +20% overweight and sentiment typically becomes a strong headwind (dashed line).

Fund managers' positioning in US equities versus the rest of the world is lowest since November 2007 and early 2015, after which the US began to outperform.

European equities: In contrast, fund managers had been excessively overweight European equities in 2015-16, during which time EZ equities underperformed. That changed in July 2016, with the region becoming underweighted for the first time in 3 years. European exposure jumped to +59% overweight in May, a 26-month high. This is well above neutral (1.7 standard deviations above its long term mean). European equities are at high risk of underperforming.

Emerging markets equities: In January 2016, allocations to emerging markets fell to their second lowest in the survey's history (-33% underweight). As the region outperformed in 2016, allocations rose to +31% overweight in October, the highest in 3-1/2 years. That made the region a contrarian short: emerging equities then dropped 10% in the next two months. Allocations fell to -6% underweight in January 2017, making the region a contrarian long again: the region has since outperformed. This month, allocations jumped to +41% overweight, near a 5-year high (1.0 standard deviations above its long term mean). Emerging market equities are at risk of underperforming.

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