When I have a bad streak trading, I do what many others do…I go to cash. There is nothing I have found that allows me to think objectively more than being 100% un-invested.
Most investors have an inherent distrust of shorting stocks, so being 100% in cash is the most defensive position they ever experience. Watching how much cash investors (and fund managers) have on hand, then, can give us a clue as to how they feel about risk in the market.
The Investment Company Institute has data going back half a century that monitors the amount of cash (or similarly liquid investments) that U.S. fund managers are holding in their funds.
Let's look at this data in a little more detail.
WHAT IS IT?
The concept of cash balances is very straightforward – the more fund managers believe stocks will head higher, the more cash they will use to buy stocks, leaving less cash sitting idle and earning a minimal rate of interest.
That rate of interest is key. It makes sense – if you were able to park your cash in a "risk-free" Treasury Bill yielding 10%, would you do that, or would you risk it in equities, knowing the long-term annual rate of return was lower than what the TBills were offering?
Surely most of you would pick the TBills, and fund managers are no different. Therefore, when we see high short-term interest rates, we almost always see funds holding high cash balances. And when rates are low, then we see low cash balances.
Thankfully, it's relatively easy to adjust existing cash balances for the prevailing level of interest rates. This strips out the interest rate factor and leaves us with a more pure read on the sentiment of the fund managers.
The Mutual Fund Cash Surplus / Deficit is a reflection of how much cash managers have on hand that is above or below how much they "should" have on hand given the return they could get in TBills. The higher the amount, the more negative fund managers appear to be, and from a contrary perspective the more bullish it has proven to be for equities going forward.
WHY SHOULD WE FOLLOW IT?
This is a long-term indicator, giving one solid signal perhaps every few years. As such, it can help us to form longer-term risk/reward profiles within which we can frame more intermediate-term views.
Over the past 50+ years, this indicator has given few false signals. It can stay in bullish or bearish territory for years on end, typically increasing the importance of the signal.
As an example, there have been 25 months when the indicator suggested that funds were holding at least 2.5% less cash than they should have been. One year later, the S&P 500 showed a negative return after 18 of those months (no small feat considering the overall market uptrend during the past 50 years), averaging -5.8%.
On the other hand, there were 35 months when fund managers were holding 2.5% or more cash than they should have been. One year after those occurrences, the S&P was higher 32 times with an average return of +13.8%.
WHAT DOES IT LOOK LIKE?
WHAT ARE THE CHALLENGES IN USING IT?
Cash levels are only released monthly, and with a one-month lag, so obviously one has to have a long-term focus in order to find any value in the data.
Changing market dynamics could be having a major impact on this information. Numerous alternatives have been created that allow fund managers to decrease their risk without actually selling stocks. Depending on their charter, they may be able to buy put options, or sell futures contracts, thereby decreasing their long-side risk without ever selling a share of stock. This would allow them to keep their cash balances low while at the same time reducing their risk.
We've also seen a rise in index funds. Most of those funds have to be nearly fully invested, and those who go against that by trying to time the market get punished. Because of the overwhelming level of assets in these passive funds, we may not see cash levels vacillate as much as we used to.
WHAT'S IT SUGGESTING NOW?
As you can see from the chart, even after adjusting for the low level of short-term interest rates, mutual funds are holding an extraordinarily low amount of their assets in liquid investments. The deficit has dropped below the 2.5% level, something that has been an ominous signal in the past for U.S. equities.
As noted above, there are some challenges in interpreting this indicator and I think they're valid. I do think we'll see an overall lower trend in fund cash assets going forward, and perhaps what we're seeing now is just the midpoint on a longer-term trend down in the data.
But we have to rely on historical comparisons, something which usually proves very fruitful despite the constantly changing market environments we experience. And right now, those historical precedents suggest there is a much greater chance for a significant market decline than market rally over the long-term of one to three years.