Feeling lost, confused, and uncertain is as much a hallmark of investing as is clarity, conviction, and a sense of calm. Because we’re all searching for answers, we have nothing to offer except our own confusion. 

What is confusing us? Not the Nasdaq’s 37 percent rally, nor that inflation has receded with so little economic pain, and not even that 10-year bond yields are breaking out. We anticipated it herehere, and here.

The confusing aspect is why institutional investors are sitting out this bull market. How long will they continue to deny?

Fact: Data from Morningstar shows $71 billion has exited US equity funds this year while bonds have gathered $171 billion in assets, even as volatility in the latter asset class has remained higher. Nearly $500 billion has flowed into money market funds, bringing total assets to a new high of $5.7 trillion.

Some context: While recession concerns are fading, the Bank of America’s latest fund manager survey shows global equity allocation is still at 11 percent underweight, which is 1.5 standard deviation below the long-term average. 

The survey shows a net 32 percent of investors are taking lower-than-normal risk. Such caution in the past was bullish from a contrarian standpoint.  

When the stock market bottomed in October, investors had 6 percent cash on hand and had the biggest bond allocation since March 2009. At 4.8 percent, cash holdings are still elevated, while they are overweight in bonds by more than 2 standard deviations.

Our take: There is currently a perception that bonds are attractive and stocks are expensive. When you can earn 5 percent in risk-free rates, why invest in stocks? 

With additional evidence of persistently above-trend growth, however, we suspect the perspective will shift: bonds are actually expensive, and stocks are cheap.  

A fiscal supercycle and a Fed that is committed to maintaining positive high real interest rates is bad for bonds. While the nominal picture is still supportive of earnings growth and equities. 

Excluding the largest eight companies, the S&P 500 is trading at 17 times forward earnings. That’s reasonable. 

ICYDK: Wall Street strategists who have been bearish all year are now revising up their 2023 targets. Remarkably, however, eighteen of the two dozen houses covered by Bloomberg’s regular survey still expect the S&P 500 to fall between now and the end of the year. 

JPMorgan’s latest client survey showed just 28 percent of respondents planned to increase their exposure to equities, even though 43 percent now expect the S&P 500 to reach a fresh record this year. Equity exposure among tactical fund managers in the weekly NAAIM survey is at the lowest level of 2023.

What this means: Though many defensively positioned investors have been forced to pare back bearish wagers, we believe many more will be forced to chase gains as the bull market unfolds. 

More importantly, the wall of money on the sidelines provides a floor as to how much equities can decline. Focus on participation and flows rather than Powell and the Fed.

The bottom line: The S&P 500 is caught in a 300-point range, between 4300 and 4600. We believe the index will break higher.