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Time to Lower Expectations?


'Bout time you finally saw things my way


Over the past few years, I've discussed and debated the cash levels of mutual funds on numerous occasions. Each time, I've been adamant that while funds were holding a low cash reserve, their behavior wasn't that unusual given the very low rate of return they were receiving on the cash that they were holding.

No longer.

The latest figures available, through June, show that funds once again reduced their reserve of liquid assets. This is in spite of the facts that June closed at nearly the same price level as May (for the S&P 500) and that short-term rates continued to creep higher. Now funds are holding about 2% less cash than I estimate they should be, and 2% is close to the "tipping point" that has led to very poor market performance historically.

The chart below shows the expected rank of forward 12-month returns in the S&P 500 given the level of mutual fund cash levels adjusted for short-term rates. For example, when the rank is 90%, it suggests that 12 months later the S&P 500 will show a return that is greater than 90% of 12-month returns in its history. When it is below 10%, it suggests the forward return will be in the bottom 10% of all returns.

As of the latest data, the expected future return in the S&P dropped to 7%, meaning that only 7% of all 12-month returns in the history of the S&P 500 would be lower than the return between now and July 2006. That's not exactly encouraging.

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No positions in stocks mentioned.

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