LONDON Perhaps the biggest investor shock of the second half of 2012 would be if everything turns out OK and the world doesn't fall apart at the seams.
As stock and bond markets hit the half-way point in yet another year of bank stress, euro crisis and disappointing global growth, early-year optimism has dissipated just as it did last year and the year before that.
But this year the gloom is already pervasive. Europe's inability to draw a line under the euro bloc's debt crisis has been the chief frustration but there's also a weary suspicion the already five-year-old credit crisis may have ushered in a western economic funk that could last a decade.
Global growth and earnings forecasts have been slashed again; euro breakup scenarios are now commonplace in investment thinking, if not positioning; hard-landing fears for the giant emerging economies of China and India are rife and nerves abound about the impact of built-in U.S. budget tightening next year.
Few could accuse strategists and fund managers of being over-optimistic.
Punch-drunk from a credit crunch most didn't foresee, investors have now become obsessed with hedging against negative "tail risks" - or events of statistically low probability, but high impact.
But is the relentless pessimism already reflected in markets and are investor positions overly skewed to now negative real returns of cash and top-rated government debt?
"Bear in mind that tail risk is a two-way concept and we focus only on the negative at our peril," said JP Morgan Asset Management strategist David Shairp, flagging an increase in equity exposure relative to bonds in JPMAM's multi-asset funds and a shift to overweight European equity from underweight.
The twists and turns of the euro crisis and fiscal debate surrounding the U.S. presidential election may be difficult to second guess. But, assuming worst-case scenarios are avoided, Shairp said there are other potential positives on the horizon.
One was declining, but still positive inflation rates worldwide as a commodity price retreat and a 20 percent year-on-year drop in crude oil prices feeds in. Assuming this disinflation allows further monetary easing by central banks while putting more spending power in consumer pockets, the outcome could prove surprising for an unsuspecting market.
"At a time when investors are nervous and running low levels of risk exposure to the asset class, any positive catalysts could prompt a shift back into equities," Shairp said.
Econ surprise vs equity premium: link.reuters.com/fuw47s
Reuters May asset poll: link.reuters.com/tej58s
Asset markets in 2012 so far: link.reuters.com/muc46s
So how skewed is market positioning?
Equity prices tell a story of stasis. When you strip away the euphoric leaps and gut-wrenching lurches, the MSCI all-country index of global stocks .MIWD00000PUS is back where it started 2012. And that's also where it started 2010.
The fear factor and tail-risk hedging, however, is more obvious in bonds. At paltry, sub-inflation rates of between 1.5 and 1.7 percent, U.S., German and British 10-year government borrowing costs have fallen yet further this year and have now more than halved since early 2010.
Repeated central bank bond buying, regulatory pressure on commercial banks to buy more domestic government bonds and the "de-risking" of pension funds are all big factors depressing yields. But investor shifts are more widespread.
Cash positions in global investment portfolios have surged again to more than 7 percent and are already back to levels not seen since the aftermath of the Lehman Brothers collapse, according to Reuters May poll of asset managers.
And the retreat from stocks has been steep, with aggregate holdings of equity in global portfolios falling below 50 percent in May to lows not seen since the bleak post-Lehman recession.
But the bit that gets many fund managers is what this does to relative valuations, particularly in Europe as the euro crisis drives outside investors away and depresses the regional economic outlook. The implied future returns on equities over top-rated government bonds, the so-called equity risk premium, remains way above historical averages.
What's more, ThomsonReuters Starmine data shows western European equity prices currently imply a decline in earnings per share of more than 4 percent per annum for the next five years and a drop of more than 10 percent a year for eastern European equities over the same period.
"Investors generally have become caught up with an awful lot of the short-term volatility and noise. But if, as history tells us, we're in mean-reverting world, then there are a lot of attractive valuations now out there," said Philip Poole, investment strategy head at HSBC Global Asset Management.
"A risk rally from here is perfectly conceivable. It's hard to see the catalyst right now but you have to think an awful lot of negativity is already in the price."
(Graphics by Scott Barber; Editing by Ruth Pitchford)