They fear that unless inflation goes down, allowing the Federal Reserve to pause its interest rate hikes or even pivot to rate cuts, the outlook for the U.S. economy and the stock market is bleak.

The S&P 500 has already cratered more than 22% year to date, and any stock market rallies have quickly been labeled short-lived bear market traps by investment banks.

But now, a new Bank of America survey shows that 87% of fund managers believe inflation has peaked, and 79% believe it will fall over the next 12 months, which could lead the way for a Fed pivot.

Bank of America researchers said that their latest fund manager survey, which includes responses from 326 fund managers with $971 billion in assets under management, also “screams capitulation.”

Capitulation is the idea that if prices fall for an extended period of time, a majority of investors panic and “capitulate” or sell their holdings. This is essentially rock bottom, after which selling pressure comes to an end, and a market rally follows.

Although it may sound counterintuitive, Bank of America has been looking for capitulation in markets this year.

The investment bank believes investor capitulation will lead to a “big low” in the stock market, which will then cause the Fed to panic about the pain it’s causing in the economy and markets, all but ensuring the end of rate hikes and a rally in stocks. And they think it’s going to happen in the first half of next year. 

“We say big low, big rally…when Fed cuts are consensus,” they wrote.

The ‘capitulation’ rally

Wait, “capitulation” is a good thing?

That’s right, in the stock market, capitulation, or a mass surrender to selling pressure by investors, can sometimes be a sign that a rally is on the way.

It may sound odd, but mass selling can transfer holdings from investors who lack conviction and are prone to panic selling to those who are more risk tolerant and willing to ride out a downturn. This can help stabilize markets and form a price bottom, or what Bank of America calls a “big low,” setting up a new rally.

Because of the pressure that a “big low” has to spark a Fed pivot next year, BofA is seeing green for the stock market.

While capitulation can’t guarantee stocks will enter a new bull market next year, Bank of America still believes that fund managers’ capitulation, or pessimism, is evidence that there are “tasty morsels for another bear rally” afoot. 

As evidence of capitulation among investors, Bank of America’s researchers pointed to the fact that 74% of fund managers believe a global recession will hit over the next 12 months, and global growth expectations are near record lows.

They also noted that cash levels in fund managers’ portfolios are at highs not seen since 2001 (6.3%), and 49% of managers are underweight equities, a sign that many are taking a low-risk approach.

The BofA team argued the survey results show investors are in “doesn’t get much worse” territory, which means a Fed pivot is likely on the way, but it probably won’t come until next year.

That’s because although the share of fund managers forecasting lower short-term interest rates in the next 12 months (a.k.a. those expecting a Fed pivot) doubled in October to 28%, that’s still far below the 65% that have expected lower rates at prior “big lows” throughout history. 

BofA said this means that a Fed pivot has yet to become the consensus outlook among fund managers. But when it does, the stock market is bound to rally.