A Bank of America survey shows that cash levels among fund managers have dropped to a record low of 3.3%, while equity positions continue to rise, reflecting unprecedented investor optimism heading into the new year. However, the valuation of the S&P 500 has surpassed levels seen prior to the bursting of the dot-com bubble, with concerns growing over excessive AI-related capital expenditures and overly optimistic corporate earnings expectations. Analysts warn that high valuations are exerting significant pressure on fundamentals, and weakening conditions in the U.S. labor market could revive recession risks, increasing uncertainty for the economic outlook in 2026.
Investors are entering the new year with extreme optimism. Despite lingering concerns about potential challenges in 2026, the current enthusiasm for going long has taken a dominant position.
According to the latest survey of fund managers by Bank of America, cash levels among fund managers have dropped significantly to 3.3% of assets under management, hitting a record low. At the same time, investor confidence in economic growth, equities, and commodities is surging, with combined exposure to these two asset classes—typically strong performers during economic expansions—reaching the highest level since February 2022.
On December 23, Bloomberg market strategist Michael Msika noted in an article that this near 'fully invested' aggressive positioning reflects how expectations for further rallies have outweighed concerns over high valuations, massive capital expenditures in artificial intelligence (AI), and earnings forecasts. Although technology stocks remain the primary driver, investors have started sector rotation over the past two months, and as more attractive investment opportunities emerge, this rotation is broadening the breadth of the market's upward movement.
The article also pointed out that strategists have warned that behind this wave of optimism, the economic outlook is not without clouds. Persistent inflation, dynamic shifts in the labor market, and the delicate balancing act of the Federal Reserve remain structural risks that investors need to be wary of.
Extremely optimistic portfolio allocation
According to Bank of America’s fund manager survey data, as the new year approaches, positioning appears quite crowded. Investors have drastically reduced their cash holdings, shifting to bets on risk assets. The cash ratio dropping to 3.3%, an extremely low level, marks the dissipation of market risk aversion and a significant rebound in risk appetite.
Typically, the start of a new year comes with a seasonal increase in risk appetite. New risk budgets, resets in performance assessments, and inflows from pension funds usually provide tailwinds for the stock market.
Although the stock market outlook for the first quarter and even April generally appears positive, historical data shows that January and February are traditionally not standout months, with recent years showing mixed performances.
Fundamental test amid high valuations
Driven by technology stocks,$S&P 500 Index (.SPX.US)$Long-term valuation indicators have reached record highs. This metric has even surpassed previous peaks before major pullbacks, such as the burst of the internet bubble in the summer of 2000 and when the market began pricing in surging interest rates in January 2022.
A team of Citigroup strategists led by Scott Chronert noted that as the current bull market enters its fourth year, continued volatility is to be expected, which could be more pronounced given the implied growth expectations.
Their team believes that while high valuations pose a challenge for the market, they are not insurmountable, thereby increasing the pressure on fundamentals to support price movements.
The article states that companies must sustain positive market sentiment through tangible earnings, and the bar is set high this time. The current market consensus anticipates double-digit earnings growth across all regions, with emerging markets leading the way.
Michael Msika considers this view overly optimistic: Asia needs to meet growth expectations, Europe’s fiscal stimulus must translate into corporate profits, and U.S. growth depends on the continued advancement of the AI revolution and resilience in the labor market.
Sector Rotation and the AI Narrative
The article points out that as valuations surge, discussions about bubbles are increasing, particularly surrounding the technology sector and AI trades. Megacap companies have raised capital expenditure commitments to levels potentially supported by their balance sheets.
While this does not currently pose a problem for the broader market, the “bond vigilantes” are ready to act.$Oracle (ORCL.US)$One piece of evidence is the sharp drop in share prices following disappointing earnings reports, with credit default swaps (CDS) surging to record levels.
Over the past two months, as AI and semiconductor trading stalled, investors have been rotating their allocations. This pattern is evident in both the U.S. and European markets, with investors beginning to chase economically sensitive stocks, defensive positions, and bets on lagging sectors.
Amid ongoing questions about AI's returns and sustainability, the rotation of portfolio themes may continue into next year. The next two to three earnings seasons could prompt further shifts as investors gain deeper insights into the health of various sectors.
Economic optimism also faces challenges.
The article also notes that despite the current high sentiment, optimistic expectations for the economy are facing headwinds, particularly given recent signs of weakness in the U.S. labor market. Additionally, the path of interest rates may once again become a focal point of investor concern, with markets currently pricing in only two rate cuts next year.
Seema Shah, Chief Global Strategist at Principal Asset Management, stated that heading into 2026, global growth remains intact but certainty has diminished. While the U.S. economy continues to benefit from AI-driven investments, robust consumer balance sheets, and targeted fiscal support, structural risks are rising.
A team of strategists at Goldman Sachs led by Kamakshya Trivedi pointed out that the primary downside risk remains deterioration in the U.S. labor market, which would bring the risk of recession back into focus.
Current market pricing suggests a low risk of recession, while the biggest micro-level threat to U.S. equities lies in challenges to the AI theme. The team recommends diversifying equity exposure internationally and across sectors, incorporating more classic cyclical stocks or cheaper defensive areas such as healthcare.
Editor/Doris