Funds Continue to Deploy Cash
Tuesday, August 31st, 2004 7:30pm EST
Cash Crunch
Bottom Line: While interest rates have risen, mutual fund cash levels have not. This unusual situation could be explained by several factors, but the historical precedents for such little sidelined cash are troubling.
The Investment Company Institute (ICI) is an organization that surveys the entire mutual fund industry and at the end of every month releases a statistical report of the industry as of the previous month. The latest figures from the agency showed something of a surprise – despite a decline of more than 3% in the S&P during the month of July, the percentage of assets mutual funds held in cash reserves stayed at a miniscule 4.3%.
There are many reasons why cash could be low as a percentage of total assets, but from our research we find that the main reason is likely the sentiment of fund managers themselves. When they feel stocks will perform well, they remain as fully invested as possible, and when they think we’re due for a decline they will raise their cash levels. Unfortunately, they tend to be wrong, and extremes in mutual fund cash levels have been a good long-term contrary indicator for over 50 years.
One problem with using the cash levels as given by the ICI is that they are greatly affected by where short-term interest rates are at the time. For example, if you are a fund manager, and see that there is a risk-free security paying you 8% per year, would you park your cash there or risk it in the stock market? Most would choose the risk-free option, and that is why we often see high cash levels at mutual funds when short-term interest rates are very high. The converse is also true – when rates are low, there is little incentive to buy short-term fixed income securities, so mutual fund cash levels also tend to be low. As a matter of fact, the correlation between the 90-day T-Bill rate and mutual fund cash levels from 1954 – 2003 was an extraordinarily high 0.74, meaning that interest rates could theoretically explain about 55% of why cash levels are where they are.
If we know that rates have an impact on cash levels, then we can try to adjust for that. That premise is the basis of the Mutual Fund Cash Premium as posted to the site. A current chart of the indicator is below.
In the chart above, when fund managers are holding more cash than they “should” be given the prevailing level of short-term interest rates, then they will be in a Cash Premium, which shows excessive pessimism on their part and which tends to be bullish for the stock market going forward. The inverse is also true – when they are holding less cash than they should be (putting them in a Cash Deficit), it is a demonstration of excessive optimism and tends to be bearish.
To highlight the difference in market performance after those times fund managers are holding too much or too little cash, I have included the chart below. It shows the performance in the S&P 500 the given number of months after Cash Premiums and Cash Deficits.
From the table, we can see that whenever funds went into a Cash Premium (the green bars and line), the S&P 500 was higher over 80% of the time one year later, with an average return of nearly 15%. On the other hand, when they went into a Cash Deficit, the S&P was higher barely 60% of the time, and the average return was less than 5%. Two years later, the performance gap was also extraordinarily wide – after Premiums, the S&P was higher more than 90% of the time, and the average return was more than double those times when fund managers were running a Deficit. If we create a simple trading system out of this, by buying the S&P when we first see an extreme Premium, and selling when we first see an extreme Deficit, there would have been 4 trades over the years. All four were winners, with an average gain of 155%. Not bad.
I bring this up now because despite short rates rising nearly 60% since January, mutual fund cash levels have stayed steady at around 4.3%. This has put fund managers into the deepest Cash Deficit in over three years. As we can see from the long-term chart above, the Deficit is still not what we could consider extreme, and even though rates have rallied 60%, they are still historically very low. So there are reasons to temper any bearish conclusions one would draw from this data, but the fact remains that funds are seemingly too bullish for their own good. I have read some reports over the past couple of months stating that certain funds were holding 30%, 40% even 50% of their assets in cash, but the ICI has what I believe are the most comprehensive numbers industry-wide, with the best history, and I defer to them.
The Dreaded Month
Bottom Line: September has a deserved reputation for being difficult for longs, and when the month leading up to it was positive, it has been even more difficult.
I promise not to belabor this point, since most of you either put no faith in this type of analysis or because you’ve already read so much about it you’re sick of hearing about it. For those of you, few as you may be, who care to know, we’re about to enter the weakest time of the year.
As you can see from the Seasonality section of the site, September has by far been the worst month for the S&P 500 since 1950. With a negative average return and less than 40% of the months being positive, there can be little doubt why the month has earned a reputation as being “bad”. None of this is new, but I do want to touch on a couple of other things.
If we look at how the S&P has performed by day of month (also available in the Seasonality section), we see that the first three days of the month are among its most positive. In fact, there are seven total days in the month that have shown a positive average return – and three of them are the first three days of the month. So historically anyway, if we are going to see any gains for the month, they are more likely to occur near the beginning.
If we go back and look at how Septembers have performed after August closed with a gain, we see that only 9 out of the following 29 Septembers were able to also close higher than they began. Over the past 10 occurrences, only 1 managed to rally in September. Something else that happened when August closed with a gain is that the “first 3 days” pattern to start September also broke down. The edge isn’t large in the first place, but it was reduced to a great degree when August was positive. The first three days in September have been positive much more often when August closed negatively than when it closed positively. One complication is Labor Day – the market tends to be quite positive the day before the holiday, and we also have the widely-watched jobs number that day.
Nearly every time I talk about these seasonal patterns, I remark that I consider them little more than a gentle wind either for you or against you. On only a few occasions each year do I consider these historical patterns strong enough to consider altering a trading plan, otherwise they are something to consider but not necessarily act on. For the coming month, the historical pattern is clearly in favor of the bears, but again to me all that means is that I might be a little quicker to take any profits from the long side and a little more hesitant to try to pick the low of any down move.
Conclusion
I’ve been mentioning in the last couple of comments that I thought lower prices were more likely than appreciably higher ones, and so far we’ve been wavering about the 1100 level on the S&P for the last 8 trading days. Many of the negatives I had been mentioning have worn off, and as of today’s close nearly every one of our short-term indicators is in neutral territory. With extremely low volume (that is not program-trading related), the questionable beginning-of-month seasonality, the pre-Labor-Day positive influences and the looming jobs number, it is difficult to recommend aggression on either side of the market at this point.
Longer-term, nothing much has changed. The mutual fund cash level discussed above is disconcerting, and I would consider it a negative factor. Also negative is the fact that margin debt on the NYSE continues to decline, according to their most recently released figures. As I’ve outlined before, we prefer to see investors taking on additional risk by buying on margin (as long as it doesn’t get out of hand). The flip side is that there is now nearly $200 Billion in cash sitting in investors’ cash and margin brokerage accounts at NYSE-designated clearing firms, a new all-time record, leaving the available cash figure the most positive since April 2003 (to see a chart, use the Chart Quick Pick feature and scroll down to “Margin Data – NYSE” under the Cash Levels section). In order for this to be a positive factor, though, investors have to be willing to take on risk by buying additional stock. Despite these negatives, the positives we’ve outlined over the past several weeks are compelling, and I continue to believe that should we see a short-term decline which puts us into an oversold condition, it should prove to be a good buying opportunity for longer-term traders.
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
Disclosure: no positions
This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.
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