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Investors Embrace Risk?

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Watch for massive marginal cash inflows into equities.

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Editor's Note: The following was posted in real time on our premium Buzz & Banter (click for a free trial). It's being shared here for the benefit of the Minyanville community.

In the face of collapsing risk aversion, current cash allocations are unsustainable.

The dramatic collapse of the VIX, first below 40 and now below 30, is a very strong indicator of sharply declining risk aversion. Based on this collapse of the VIX, and my interpretation of the historical data series, I believe that we will very soon see a collapse in another key indicator of risk aversion: cash allocations.

Other indicators are signaling a clear shift of risk preferences; specifically, a clear decline in risk aversion: corporate high yield spreads, emerging market bond spreads, emerging market capital flows, and capital markets deal flow, just to name a few. My interpretation of the various historical data series leads me to the conclusion that a massive decline in cash allocations is imminent.

Furthermore, history has shown that once the aforementioned risk preference indicators start trending, they exhibit strong persistence characteristics. This indicates that these indicators have a great deal more to run, and there's very limited risk that we're at the tail end of the trend in declining risk aversion. To the contrary, analysis of all of the indicators reveals that the decline in risk aversion is likely to persist and progress much further.

In the face of the strong reversal of these risk-preference indicators, and the fact that the markets have likely only completed the first phase of a longer medium term trend, it's my contention that current cash allocation levels are unsustainable.

Conversely, equity allocations are at historically low levels. In the face of improving economic fundamental trends that are now in evidence -- and that have effectively eliminated the most apocalyptic scenarios, at least for now -- I have little doubt that equity allocations will be a direct beneficiary of the dramatic decline in risk aversion and the consequent reduction in cash allocations.

Improving fundamentals + collapsing risk aversion + extremely high cash allocations = massive marginal cash inflows into equities.
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No positions in stocks mentioned.
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