Bullish sentiment has risen to extreme levels not seen since 2021! As U.S. stocks rebound, Bank of America dampens the mood: investors should reduce exposure to risk assets.

Bank of America strategists have warned that investor bullish sentiment has reached extreme levels, signaling that it is time to begin reducing exposure to risk assets. The team of strategists, led by Michael Hartnett, stated in a report that the bank's "bull-bear sentiment indicator" has risen to its highest level since 2021, increasing from 9.4 to 9.7. The strategists pointed out that the broadening gains in the stock market, significant inflows into high-yield bonds, and a narrowing credit spread are the primary reasons driving the optimism among investors. However, the Bank of America strategists prefer defensive assets, believing that such assets help protect portfolios from potential negative shocks related to the economy, monetary policy, and the artificial intelligence (AI) sector. Hartnett stated, "We are still in the 'summer withdrawal/rotation' camp, rather than the 'rebuild positions' camp." He advises investors to reduce their risk asset allocations or shift towards certain defensive assets, duration assets, and the U.S. dollar. As the Bank of America issues this warning, robust earnings reports have boosted investor confidence in the AI outlook, leading to a dramatic reversal in U.S. tech stocks, as investors re-enter those tech stocks that had previously been sold off. U.S. stocks reached a historical high this week. Investors are awaiting the upcoming U.S. non-farm payroll report for July to seek new clues regarding the Federal Reserve's next policy moves. The performance of the U.S. second-quarter earnings season has significantly exceeded expectations, reaffirming investors' belief that massive AI investments will not only persist but have started to yield returns for some industry giants. Data shows that the cloud business backlogs for large-scale cloud service providers surged more than 150% year-on-year, reaching approximately $1.7 trillion, far outpacing the roughly 80% growth in capital expenditures over the same period. JPMorgan noted that this significant gap indicates that the potential revenue returns from AI infrastructure investments are surpassing market expectations, suggesting that the valuation absorption pressure on tech giants may be nearing its end. However, following this strong earnings season, the specific growth numbers have made some investors cautious. According to the latest internal report from Goldman Sachs' sales and trading division, the year-on-year earnings per share (EPS) growth for S&P 500 constituents in the second quarter reached as high as 45%but excluding the fair value changes from equity investments held by large tech companies, this figure nearly gets halved to 26%. In other words, about half of the "record" earnings growth comes from tech giants revaluation of their risk investment portfolios rather than from substantive expansions in operating profits. Stocks related to AI infrastructure contributed to about one-third of the total EPS growth for the S&P 500, further highlighting the high concentration of earnings growth. These figures imply that the profit basis upon which current valuations rely is far more fragile than the superficial numbers suggest. Moreover, during this earnings season, tech stocks still have a 90% probability of exceeding earnings expectations despite high pressure from those expectations, while analysts are continually raising their earnings forecasts. However, while earnings expectations have been revised upward, tech stock valuations have experienced a notable compressionfollowing the market adjustment in July, the forward price-to-earnings ratio of the S&P 500 Information Technology sector fell to around 20 times, close to the lowest level in the past year and at the 1st percentile of the historical valuation range, below the average level of about 23 times over the past decade. In this regard, JPMorgan pointed out that the forward price-to-earnings ratio of large-cap tech stocks (excluding semiconductors) is currently more than 2 standard deviations below the historical mean since 2018. If valuations were to recover to one standard deviation below the historical mean, it would correspond to about a 30% upside potential; if restored to around the long-term average, the potential upward space could reach about 56%. It is worth noting that during last month's tech stock adjustment, massive deleveraging led hedge funds and other fast trading funds to close out a large number of short positions. Currently, this capital has re-entered and started buying into the tech sector. According to data from Goldman Sachs' Prime Brokerage division, last week, hedge funds increased their holdings in technology stocks at the fastest pace since December 2022. The Goldman Sachs team indicated that all of the "seven giants" gained capital inflows, but the overall holding levels remain relatively low, suggesting that there is still room for further increase in positions. Despite multiple major Wall Street firms pointing out that the ongoing deleveraging in the U.S. tech sector has nearly reached its end, macro risks continue to accumulate. For instance, Goldman Sachs derivatives expert Lee Cooper-Smith warned that as the earnings season concludes, the market's focus will shift back to interest rates, inflation, and economic growth. The volatility of U.S. Treasury bonds has started to accelerate again, with real yields remaining close to cyclical highs. The team led by Alain Bocobza from France's Industrial Bank highlighted that the second round of U.S. tariffs, the accelerated growth of AI and infrastructure capital expenditures, heightened oil price volatility, and the continued massive fiscal deficits in developed economies all indicate that market expectations for inflation are "much lower." The Industrial Bank of France predicts that this year's core PCE will remain above 3% and recommends allocating inflation-protected securities (TIPS), copper, and gold as inflation hedges.