Be cautious of overly optimistic market sentiment! The bears "resigned" and fled, reducing the upward momentum of US stocks by one.

For bullish investors in the U.S. stock market, a worrisome thought is that the bears are exiting.

The S&P 500 index just experienced its strongest first half performance in five years, and the actions of bearish investors exiting the market have shown signs of acceleration. As the trend turns upward, the short sellers, who were prepared to make a big profit in 2023, have been withdrawing their positions along with the stock market rebound, which was originally a source of anxious buying.

Data shows that bearish positions in exchange-traded funds (ETFs) have dropped to a three-year low, while short positions in S&P 500 index futures have been closed at the fastest pace since 2020. At the same time, the number of bullish investors in the U.S. stock market is increasing. According to a survey by Investors Intelligence, the ratio of bulls to bears is 3:1, the highest level since the end of 2022.

As an investment axiom, the best market backdrop for long-term investors should be "when others are fearful, be greedy." Just as the market performed well for the bulls since hitting bottom nine months ago, this helps explain how good the performance of the bulls has been.

Now, the strength of the U.S. stock market rebound is putting pressure on the bears. The exit of the short sellers deprives the market of a catalyst for further gains, as concerns about the Federal Reserve's fight against inflation resurface amid expectations of a third consecutive quarter of declining corporate profits.

Adam Phillips, Managing Director of Portfolio Strategy at EP Wealth Advisors, said, "Market sentiment is not extreme, but there is some nervousness. Recent surveys suggest that the stock market will not be able to sustain the same momentum going forward. Looking ahead to the second half of the year, we expect the market to be tested as investors need to prove the rationale behind recent performance."

According to analysis provider Ortex, short sellers may have lost $37 billion in June. The double-digit returns of the S&P 500 index, driven by optimism about artificial intelligence, have shocked pessimists in the U.S. stock market, resulting in increasing losses for the bears throughout the year.

Increasing signs indicate that skeptics of the uptrend are retreating after initial resistance. Large short-selling speculators are busy closing their positions in the coming weeks. These speculators are mostly hedge funds, whose net short positions in the S&P 500 index soared to record levels at the end of May. According to data from the U.S. Commodity Futures Trading Commission (CFTC), their bearish positions decreased by 226,000 contracts during this period, the largest decline since mid-2020.

In the group of newsletter authors tracked by Investors Intelligence, the percentage of bullish individuals has risen to 54.9%, while the percentage of bearish individuals has dropped to 18.3%. This is in stark contrast to the end of last year when the bearish percentage exceeded the bullish.

The rapid shift in market sentiment has even prompted Ed Yardeni, the president of Yardeni Research and an early advocate of this bull market, to question whether there are too many stock market optimists. Yardeni stated, "Heightened bullish sentiment may be a warning signal." He boldly predicted in January that the stock market would continue to rise, and it turns out he was prescient.

Markit data compiled by Morgan Stanley's sales and trading team shows that, in the ETF market, short equity positions are near a three-year low when measured by market value. Although short positions in individual companies have not completely disappeared, they have fallen back to median levels in most industries.

As the market continues to rise, fund managers who have been forced to buy stocks include rule-based managers. Morgan Stanley's team estimates that systematic funds, including those that allocate assets based on price momentum and volatility signals, bought $40-45 billion of global stocks in June, noting that this buying pace since January is the second fastest on record (measured over a six-month period).

Based on the current situation, the stock exposure of quantitative analysts has risen to the highest level since February 2020, hovering around the 80th percentile over the past five years. A team led by Christopher Metli, Morgan Stanley's Head of Quantitative and Derivative Strategy, wrote in a report, "This implies that any sustained equity demand from this group will become more fragile." They estimate that if their risk exposure returns to historical median levels, it could result in selling up to $160 billion worth of stocks.

Currently, the stock market correction has been relatively small, partly because traders are waiting for more economic and corporate earnings reports to better understand the fundamental outlook. The S&P 500 index has gone 17 weeks without a 2% weekly decline, marking the longest continuous rebound in nearly two years. Large banks will kick off the earnings season next week, and analysts expect a 9% contraction in second-quarter profits for companies in the S&P 500 index, according to data. From the perspective of investors' positions, the market generally lacks confidence in the economy. An analysis report from Bank of America shows that although active funds have been chasing returns in the rise of technology stocks driven by artificial intelligence this year, they have reduced their exposure to economically sensitive companies such as energy. The strategist of the company, Savita Subramanian, said that in fact, the group's cyclical risk exposure and defensive risk exposure are hovering near historical lows.

Matt Frame, a partner at the stock-picking hedge fund Bornite Capital Management, said that the continued aversion to cyclical stocks reflects the view that economic recession has been postponed but not completely avoided. He said, "At the index level, we have shifted from extreme bearish sentiment in the autumn of last year to another extreme, especially in technology stocks. I don't think it's fair to say that all industries are the same. Technology stocks and the overall market have risen so far this year, while cyclical stocks have fallen around the theme of economic recession. If the stock market is to continue to rise, you need to see some participation beyond technology stocks."