Investor exuberance could be the biggest risk facing financial markets

Oli Scarff/Getty Images.

  • A huge survey finds investors think stocks are over-valued, but a record number recently took on increased levels of risk
  • Investors also think these more risky positions are “crowded trades”, meaning there could be a damaging rush to the exits

The global economy is looking better than at any point in the past decade, and financial markets reflect that.

Stocks sit at — or near — record highs, commodity prices have rallied, corporate debt remains in vogue and volatility sits near-record lows.

Understandably, investor sentiment is near-euphoric with recent gains encouraging ever-increasing levels of risk-taking, including from fund managers.

According to the latest Fund Manager survey released by Bank of America Merrill Lynch (BAML), a record number of respondents took on higher-than-usual levels of risk during the past month, presumably in response to continued gains in markets and improving global growth outlook.

Despite the lift in risk-taking, a record-high net 48% of respondents also said stocks — the epitome of a risk asset — were currently overvalued.

So even though a record number of fund managers think stocks are overvalued, they still took on increased levels of risk in November.


BAML thought so, describing it as a sign of “irrational exuberance” among investors.

The risks, and to some rationality, are being pushed to the side for the moment as investors favour chasing assets they they already deem to be overvalued.

For all the geopolitical concerns surrounding North Korea, the Middle East and, more recently, Zimbabwe, this is perhaps the risk facing markets right now.

Exuberance is high, risk assets are deemed overvalued and positioning in stretched.

Sounds like more than a small risk, and fund managers agree.

Just have a look at this chart from the BAML survey showing those trades that respondents think are the “most crowded” at present. For those not up with the markets lingo, “most crowded” is essentially where investors are all positioned for the same outcome to occur.

Source: BAML

Being long stocks dominates the list, particularly the tech-heavy Nasdaq index in the States.

New entrants to the list also include selling volatility, a trade that has allowed stocks to surge this year, along with being long high-yield corporate debt — again, another risk assets that has performed well this year.

So not only do fund mangers think risk assets are overvalued, they believe positioning in these assets is lopsided. And they think the trade of selling volatility at already depressed levels is also looking stretched.

While this doesn’t automatically imply that a sudden selloff in the markets will occur — it is only one survey after all — this kind of mindset will raise red flags among contrarian investors.

Let’s be honest, things are looking a tad frothy.

Given sentiment, positioning and mindset towards asset valuations, one suspects that the risk of a meaningful pullback is growing.

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