The 'pain trade' is for stocks to keep going higher as rally catches most investors off guard

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Investors have waded back into the stock market after fleeing in June, but with a skepticism that could keep the current rally from overheating, according to the latest Bank of America Merrill Lynch Fund Managers Survey.

Market pros in July reduced cash allocations, though still to a point that is well ahead of historical averages. At the same time, survey respondents said they rotated back into risk, particularly in the more cyclical parts of the market like industrials, banks and European equities. In doing so, they cut back on safe haven bonds, utilities, consumer staples and real estate investment trusts, the survey indicated.

After shell-shocked investors responded to May’s sharp selloff by cutting stock exposure, expectations for lower interest rates and less fear about tariffs sent them back into the market and set up what could be a profitable run ahead.

“The dovish Fed and trade truce have caused investors to reduce cash and add risk, but their expectations of an earnings recession and debt deflation still dominate sentiment,” Michael Hartnett, BofAML’s chief investment strategist, said in a statement. “The pain trade for the summer remains up in stocks and yields.”

“Pain trade” is a term for a market move that catches investors off guard. Hartnett’s statement, then, implies more gains for the stock market and a drop in bond prices, which move opposite yields.

Worries about the Fed

While investors did come back to the market this month, the average cash balance in portfolios remains at 5.2%, above the 10-year average of 4.6%. The June level of 5.6% was the highest cash allocation since August 2011.

The Dow Jones Industrial Average tumbled nearly 7% in May but has rebounded since and is up 2.8% in July.

Investors are will most worried about the U.S.-China trade war, though the 36% of respondents who cited the tariff issue is a sharp decline from 56% in June.

Worries that monetary policy will not be effective climbed into second place, with 22% citing the Fed fear factor. Markets widely expect the central bank to cut its benchmark interest rate by at least a quarter point later this month, followed by one or two more reductions by the end of the year.

Those concerns, though, didn’t stop a move back into risk. 

Respondents most preferred emerging markets, with a net 23% of respondents saying they are overweight that part of the market. U.S. stocks and the euro zone tied for second.

The professionals also said they are worried about corporate leverage, with a record 48% saying they are worried about company balance sheets.

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