Fundamental investors retreat, yet quant funds keep chasing the rally! US stocks see widest 'human vs. machine' divergence since 2020, market fears sharp reversal.

Those fund managers focused on economic growth and corporate profitability are increasingly skeptical about the sustainability of this US stock market rally. Data compiled by Deutsche Bank shows that concerns about elevated US Treasury yields, the Middle East war, and sticky inflation have pushed discretionary investors' equity exposure to the bottom third of its historical range. But at the same time, quantitative funds have continued buying stocks, benefiting from the benchmark index's sustained gains and declining volatility. The data shows that the gap between the two the former underweight and the latter overweight US equities is now the second-largest since 2020. Deutsche Bank strategist Parag Thatte said in a telephone interview: "At this point, this gap can't widen much further, so one side will soon have to give way." If stock prices continue to rise, quant funds typically don't care how much the market has already risen, so they will have to keep buying, eventually forcing fund managers to capitulate. Conversely, if selling returns to the market, discretionary investors who have largely missed this rally will be drawn in and get a chance to prove themselves right. The gap between discretionary and systematic equity positioning is the second-largest since 2020 Although systematic funds are not considered the largest participants in the market by assets under management, they are undoubtedly among the fastest-moving participants. When their algorithms hit a specific threshold, such as a buy or sell signal, they immediately close or add positions. This can cause tens of billions of dollars to flow into or out of major stock indexes. Maxwell Grinacoff, head of equity derivatives research at UBS Group, said the S&P 500's one-month realized volatility is currently around 9.9, the lowest level since June. Under these conditions, volatility-control funds have been buying stocks. Such funds typically increase equity positions when the market is calm and sell stocks when market volatility intensifies. Maxwell Grinacoff added: "Only an exogenous shock that causes the S&P 500 to fall sharply for multiple consecutive trading days could force a reversal in systematic positioning and trigger a 'cascading outflow' of funds from the stock market but we haven't seen that yet." Despite market concerns about a bubble in artificial intelligence (AI) stocks and long-term borrowing costs rising to their highest levels in decades, US stocks have recently had smooth sailing. The S&P 500 has risen 23% since its March low, adding $13 trillion in market value during that period. The benchmark index has gone 89 consecutive trading days without a drop of at least 2%, while only two trading days this year have seen such a decline. Data compiled by Charlie McElligott, cross-asset strategist at Nomura Holdings, shows that systematic funds, including volatility-control funds, commodity trading advisors (CTAs), and risk-parity funds, have now restored their equity exposure to the 86th percentile, close to this year's high. Parag Thatte said that given how systematic funds operate, a market selloff could begin with volatility-control funds unwinding extreme positions. He added that this would increase the risk of a sharp stock market reversal, though for volatility to spike and stay elevated for a period, the market would need a large-scale selloff that is, the S&P 500 falling at least 5% from its peak. Volatility-control funds' buying and selling activity is inversely related to realized volatility: the larger the price swings, the stronger the de-risking signal sent to volatility-control funds. This happened in the spring of this year, when volatility rose sharply as market concerns about the Middle East war and economic conditions intensified. As their sensitivity to market selloffs increased, these funds reduced equity exposure. Parag Thatte said that if discretionary investors begin selling stocks out of concern about weakening economic growth or deteriorating corporate earnings trends, this could in theory push up market volatility and force algorithm-driven strategies to unwind positions as well. But that doesn't mean the market rally can't continue. Discretionary fund managers' currently low equity positioning means investors still have more "ammunition" to buy stocks in the coming months, helping avoid a more severe market selloff. Colton Loder, managing partner at alternative investment firm Cohalo, said: "There are indeed some investors in the market who are underweight the 'right' stocks, and they will step in to buy on a market pullback. Something will definitely emerge to push up volatility or create a negative stock trend. Systematic strategies can last a very long time; it will keep going until it no longer does."