Investor pessimism is at an all-time high

After a brutal period that led the S&P 500 to its worst start to the year in two decades, investors are predicting even worse stock market declines.

Recent negative bets on US stocks by asset managers and hedge funds are at their highest since 2016, when concerns about a global slowdown were at an all-time high. That’s what futures contracts for major stock indices show, according to research by JPMorgan Chase & Co.

An assessment by the National Association of Active Investment Managers (NAAIM), which surveyed primarily registered investment advisers, found that the average active investor has steadily reduced their exposure to stocks this year and lost stock allocations to one of the lowest levels since the start of the pandemic.

Yet, several indicators of market sentiment provide mixed messages. According to a study conducted by the Federal Reserve Bank of New York, the majority of Americans (about two-thirds) believe that stock prices will remain relatively stable or fall in the coming year. Since the creation of the survey in 2013, this ratio is the highest ever reached.

Many investors are understandably reluctant to put their money on the stock exchange, as evidenced by positioning and mood statistics. The bull run on major indices that began at the height of the Covid-19 outbreak ended this year with a thud.

What is causing all these worries? A looming recession and steadily rising inflation are causing concern. Following the release of new economic statistics showing inflation at its highest level in 40 years, the S&P 500 fell 0.9% this week. The broad stock index has already fallen 19% for the year, its worst performance so far since 2002, according to data compiled by Dow Jones Market Data.

According to Parag Thatte, strategist at Deutsche Bank, “everyone is concerned about the risk of recession”.

The bond market’s most predictive indicator of recession – the inverted yield curve – recently hit its widest level in two decades, signaling a warning message to the rest of the economy. In addition, many investors raised bets that the Federal Reserve would raise rates by a full percentage point at the next meeting – this hadn’t happened in decades.

Deutsche Bank estimates suggest investors have reduced their equity holdings to record levels over the past 12 years. This includes reducing the holdings of systematic funds that trade in response to market volatility and other factors. Meanwhile, traders big and small alike have cut their bullish bets in the options market to the lowest level since April 2020.

Dunn Capital Management chairman Martin Bergin said his company was bullish on stocks for much of the year, but began to cut bets and took a somewhat bearish stance in the futures market in course of the last month. Mr. Bergin is in charge of a trend-following approach, whereby investment choices are made systematically based on the performance of different assets and the linkages between different positions in his portfolio.

“We have now established that it is better to be a bit short rather than long,” Mr. Bergin added. We will start taking additional long exposure if there is a bounce.

Investors this year have been hit with even more uncertainty due to: Some of the largest swings in market history have been seen across a wide range of asset classes, from bonds to commodities and currencies. For this reason, some investors have been hesitant to place large bets for fear of being caught off guard if the market suddenly reverses. Some analysts, like Mr Thatte, have suggested that investors could still benefit from reducing their exposure to equities, even after a particularly difficult period for the market.

Roberto Croce, head of risk parity at Newton Investment Management Group, recently said: “It’s as dangerous as it has been in the last 11 years that I’ve been doing this.” There could be more bad news for the market.

Mr. Croce is in charge of a risk parity strategy that determines when and how much to buy or sell stocks, bonds and commodities based on their perceived volatility and risk at any given time. During this year’s market volatility, he predicted that many such methods would reduce their stock market bets.

Rather than buying bonds, which have fallen as a group, many individual investors appear to be hoarding cash. According to a June study by the American Association of Individual Investors, this is the largest percentage of cash reserves that individual investors have kept since the start of the epidemic.

After watching their investments plummet, some traders are hoping to cash in big. Since the start of 2022, trading volume has increased significantly in two of the major exchange-traded funds that offer increased exposure to stock market losses by placing bets against the Nasdaq-100 and S&P 500 indices. According to calculations by JPMorgan , retail investors continued to buy this year, albeit at a slower pace.

Seen through a contrarian lens, the current level of caution in the stock market may provide hope for the rest of the year. As a JPMorgan team led by Nikolaos Panigirtzoglou reported, the massive sell-off by institutional investors in the first half of 2022 could be followed by a return to the markets in the second.

Classic investor behavior, according to Andrew Slimmon, managing director and senior portfolio manager of long equity strategies at Morgan Stanley Investment Management. “People are reacting to what has already happened by being cautious too late,” he said. Some stocks that performed poorly in the first half of the year could see better results in the second.

Mr Slimmon said he reduced his exposure to defensive stocks that had performed well in the first half of the year in favor of buying stocks in sectors that had been particularly hard hit, such as the homebuilding sector.

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