Contrarian signals are written all across the Bank of America-Merrill Lynch (BofA-ML) survey of global fund managers for February. The BofA-ML risk appetite indicator, for instance, stands at +47, the highest level since January 2006. Allocations to equities are at an all-time high, with a record 67% of investors now overweight equities.

This level is more than one standard deviation above the average, and BofA-ML says this “makes it vulnerable to any macro disappointment", although it hedges its bets by saying it could also be part of a structural shift away from bonds.

Hedge funds are back in action, with their net exposure reading at its highest since July 2007, and with high gearing levels.

Also See | Huge fall in EM allocation (PDF)

The US market has been the main beneficiary of this upsurge in bullish sentiment and a net 34% of investors are now overweight the US, up from 27% overweight in December. That allocation is above two standard deviations more than the long-run average, and BofA-ML says US equities are “in potentially over-owned territory".

Allocation to commodities, too, has moved up to a record 28% overweight relative to benchmarks, from a net 16% last month. In contrast, as emerging markets (EMs) tottered on account of inflation fears, fund managers’ positioning in global EMs fell to a net 5% overweight, from a net 43% last month. The result of all this bullishness is that cash balances with fund managers are down to 3.5%. Asset allocators’ positioning in cash is a net 9% underweight, the lowest reading since January 2002.

Should this over-exuberance lead to a fall? BofA-ML says it should, and adds that its contrarian regional pair trading rule has been triggered, “which now suggests to buy EM and sell US".

It also says that the low cash balances have triggered its equity sell signal, which indicates all equity markets could be vulnerable to a correction. BofA-ML says: “A level of 3.5% (of cash balances) or below has in the past signalled an equity market correction on a four-week horizon." Tighter policy or weaker data could be the spark for the trades to unwind.

What are the contrarian trades? “Long bonds, short equities; long dollar, short commodities; long Japan and EM equities, short US; long staples/utility stocks, short tech stocks." That would mean a reversal of the “sell emerging markets, buy US equities" trades of the past few months.

BofA-ML says the risk of further downsides in EMs is low, because allocations have already been cut so savagely. But it also adds, “We believe a peak in EM inflation or upside surprises to China growth are necessary to provoke fresh inflows to EM."

India remains the biggest underweight among Asia-Pacific investors and among the big underweights among global EM investors. That could temper inflows when the rotation back from the US markets occurs.

Graphic by Ahmed Raza Khan/Mint