Morning Market Commentary:
- Fourth-quarter earnings results accelerate this week for S&P 500 Index member companies.
- Institutional investors are cautiously positioned ahead of the results.
- Better-than-expected numbers could result in a flood of cash being invested back into equities.
Institutional investors are poorly positioned for a stock market rally...
There's an old saying on Wall Street... The stock market tends to do what hurts the most people the most. What it means is when the majority of investors are positioned the same way, the stock market tends to have the opposite reaction.
It's similar to the 'Greater Fool Theory.' The idea is that when everyone has bought into the same asset, there's no one else left to buy. In other words, there's nothing but downside. That's common during market peaks.
Right now, the S&P 500 is facing another important test over the next few weeks. We're getting into the thick of fourth-quarter earnings. The process got underway with JPMorgan Chase's (JPM) results on January 13 and essentially wraps up when Disney (DIS) details numbers on February 8.
So, we want to look at positioning to see what institutional investors are anticipating ahead of the results. By observing those metrics, it gives us a better idea of the setup. And when we understand the data, we get a better sense of what the stock market outcome may be if results don't fare as well or as poorly as most investors are anticipating.
Based on current positioning, sentiment is low and money managers are cautious. That means they're anticipating disappointing results. So, the worst possible outcome is numbers that are in line to better.
That tells me the setup going into numbers is for a continued rally in the S&P 500.
But don't take my word for it, let's look at the data...
Every Friday at 3 p.m. Eastern time, the Commodity Futures Trading Commission ("CFTC") releases its Commitment of Traders ("COT") report. It's based on the open interest of all options and/or futures contracts through the Tuesday prior. It also includes markets if 20 or more traders hold a position equal to or above reporting levels established by the CFTC and the respective exchanges.
We want to follow the noncommercial positioning in particular. A commercial trader uses futures-contract positioning to offset a specific commodity or hedge. But noncommercial traders are speculators who make a one-sided bet without an offsetting position. Typically, these are hedge-fund managers.
The best way to get an idea of current sentiment regarding the stock market is to study the open interest on the S&P 500. Based on the most recent report, fund managers are almost as short stocks as they were at the COVID-19 pandemic lows. In fact, those short bets have increased since the start of this year...
The current positioning is short more than 226,800 contracts. That tells me those money managers are anticipating the S&P 500 is headed lower because they expect earnings results to disappoint. But, as we can see, the last time they were more pessimistic was just after the stock market bottomed out in April of 2020 and the recent trough in October of last year.
The five-year average is long right around 16,500 contracts. So, if those bets against the S&P 500 are wrong, there's a lot of room for the market to move higher because of the consequent short covering that could take place.
Next, let's look at the amount of investor assets sitting in cash. We can observe this by looking at the Investment Company Institute's ("ICI") money market assets. And as we can see, the number hasn't been this high since May 2020...
Currently, the total amount of funds invested in the cash-like safety of money market assets is $4.8 trillion. That's right in line with the $4.8 trillion total during the height of the COVID-19 pandemic. It's also well above the five-year average of $3.9 trillion and the one-year number of $4.6 trillion.
More importantly, that's a signal there's a lot of excess capital waiting to be put back to work investing. By sitting in money market assets, those funds are making little to no return. If the stock market keeps rallying, those investors are missing out on gains. Eventually, they'll be forced to chase.
Lastly, let's look at investor positioning in U.S. equities from the Bank of America Global Fund Manager Survey for January. As we can see, it has only been this cautious five other times in the last 25 years...
And when that's been the case, the returns on the S&P 500 have exceeded the lifetime average of around 9.1%...
We must remember the stock market is the ultimate barometer of performance versus expectations. When expectations are high, they're hard to beat. And likewise, when they're low, it's difficult to underperform. And based on what we're looking at, numbers had better be awful.
Otherwise, all of those assets sitting in cash will be missing out on returns. And when that happens, it will slowly but surely start trickling back into stocks. And before we know it, that steady stream will turn into a flood, fueling a rally in the S&P 500.