Volatility Is Driving A Move To Cash

04/02/09 8:50 AM EST

Good Thursday morning...We begin the day with some heavy buying interest in the pre-market futures as positive vibes emanate from the G-20 meeting and markets around the world climb higher.

Back in January, we touched on the asset allocation preferences exhibited by the individual investors in the AAII sentiment survey.  At the time, they had moved as much money into cash as stocks, the first time in that survey's history (going back to 1987) that they'd done so.

They quickly changed their tune during February, reducing their cash pile from 42% of total assets down to 30%.  They put that money mostly into bonds, but also a bit into stocks.

The failure to see any kind of lasting bounce until mid-month in March seemed to have spooked them once again, however, and they surged back into cash in the latest survey while pulling out of both stocks and bonds.  Currently, they are holding a new all-time record high of cash.

Similar to the professional strategists on Wall Street, investor allocations to stocks are drifting along near multi-decade lows. 

It isn't just the fact that stocks are declining that drives the allocation to stocks.  Volatility plays a big part, too - if stocks are volatile, then individual investors become less willing to hold them, and vice-versa.  Granted, stocks and volatility are very closely correlated, but we can also see the close correlation between volatility regimes and cash levels.

As volatility gets tamped down (assuming it does), we should see cash levels recede even if stocks cannot make a lot of upside progress.

While these surveys can be poor from a market timing standpoint, from a long-term perspective it seems wholly unlikely that the massive amount of caution from these groups will be rewarded.

It isn't just investors that are pessimistic, of course, the population in general is as well.  All of the economic sentiment surveys we follow and post to the site are at multi-decade or all-time lows.

The most recent Consumer Confidence survey did show a slight uptick from the prior month, but we've seen several false starts over the past two years in that survey.  According to the chart below, we probably won't see a sustained rebound in confidence until the downward momentum of the bear market begins to abate.

While the Consumer Confidence survey is not based solely on the stock market, it is a big source of peoples' feeling of wealth, and their confidence ebbs and flows along with the S&P.

We can see from the chart that troughs in confidence tend to occur at least a few months following a trough in the negative rate-of-change in the S&P.  Given the severity of the decline last summer, it's going to be pretty tough to see a big rebound in the rate-of-change until this fall.

Perhaps that's in the cards - we just witnessed only the second time since 1970 that the S&P 500 suffered six consecutive negative quarters.  The only other instance ended in the 2nd quarter of 1970.  The third quarter that year was +15.9%, and seven of the next ten quarters were positive (two just barely negative), with a total gain of over +62%.

Bottom line - Intermediate-term

Nearing the end of the first week in March, we went over a number of indicators and studies suggesting that we were very likely within days of an inflection point.  Sentiment had reached an extreme (the setup) and the price pattern coincided almost perfectly with past lows (the trigger).

The market failed to follow through immediately on the upside, which was messy and somewhat unusual, but still basically within the confines of the risk parameters mentioned in the past studies.

After March 10th's "blast off" day, we needed to see some short-term follow-through, per the tables from Wednesday and Friday that week.  We unquestionably saw that, which basically means that it would be unprecedented to not see generally higher prices over the next one to three months.  Pretty much everything we've looked at since then helps confirm that.

Last week, we started to see more troubling readings, and after the 20%+ rally we've seen, the outlook has been growing a little dimmer.  It has seemed more likely that we would be entering a multi-month trading range, with 875ish the likely upper end of that.  As we flirt near the upper end of that range, it makes sense to expect the risk/reward to tilt more towards the "risk" and less towards the "reward" on long positions, and I will likely become significantly less optimistic the closer we get to 875ish, especially if we see the Dumb Money Confidence hit 60%-70%.

Bottom line - Short-term

Late last week, we looked at several factors lining up for a pullback, or choppy conditions at best.  Several guides had reached exceptionally stretched levels, and seasonality was tilted more towards the bears than bulls if anything.

I'm not a huge seasonality fan, but in an intraday note yesterday we looked at what's happened when the first trading day in April has been as positive as yesterday, and it led to still-higher prices 9 out of 10 times, so with neutral intraday guides I was less inclined to try selling into the 812-815 area that was my initial short-term target.

That April stat is taken in a vacuum, without consideration of the pending G-20 announcements or the jobs report on Friday.  Per the chart we showed on Tuesday, it's pretty clear that economic results have been coming in better than expected, and that is likely seeping into investors' attitudes.  We're probably past the point where bad news could be considered good news, and it doesn't seem likely that a bad jobs report will get the same reception it got last month.

The next two days are going to be heavily news-driven, and most of our shorter-term indicators are still neutral even after yesterday's rally.  Last week's high around 830 should be resistance in the S&P, and in fact we pulled back from a kiss of those highs in the pre-market futures.

That'll be the main thing I'm watching today, especially during the first hour of trading.  As usual, with such a large gap open as is indicated this morning, if we're going to fail, then it's probably going to be during the first hour.  A higher intraday high after that point, especially if we're above last week's highs, should let us close higher still.  The only short-side trade I'd see at that point would be a rally toward 850 with overbought conditions and a gap up on the jobs report tomorrow.

All the best,