Trader’s Narrative

We’ve touched on the epic amounts of cash that are sitting on the sidelines in money market funds. There is some debate about how positive this is for the market so let’s take a closer look by going over a few details from both sides of the argument.

Money Market Levels
Now that we have stepped away from the precipice (or so it would seem), it may be difficult to imagine the magnitude of fear that drove the vast majority into the safety of cash. At its zenith, we had almost half the capitalization of the total US stock market sitting in money market funds.

Here’s a chart of the aggregate US equity market capitalization compared to the total assets held in money market funds (click to see full size chart):

And at the March 2009 low, for the first time in 16 years, US money market funds had more assets than US equity mutual funds: Tsunami of Cash Waiting to be Invested. Since March 9, the value of U.S. equities, measured by the Wilshire 5000, has increased by $4.4 trillion. And from its high the level of total mutual fund cash has fallen by $341 billion.

However, before you get excited and start to think this means we are about to embark on a wild bull market, consider the astute point made by Gestalt: that the increase in money market assets may be a mirage as corporations have shifted short term liquid assets from commercial paper to institutional money market funds.

Mutual Fund Cash Levels
Jason Goepfert wrote an award winning research report in 2004 regarding the signal value of the level of cash held by mutual funds. You can get a copy of the research report from the free trading resource section (Charles H. Dow Awards folder).

As you can imagine, it is an important point in all this is that nominal interest rates are negligible. This means there is little incentive to park assets in cash. But then again, if you follow the strong indications of deflation, the real interest rate is 6.5% - which is actually a significant incentive to just let your money grow (albeit slowly) with near zero risk.

Unfortunately, Goepfert’s research report does not take into consideration inflation or deflation but simply adjusts the level of mutual fund cash levels according to the 90 day T-Bill rate. I’ve sent him a message about this so hopefully when he’s back from vacation he can update it with this new twist thrown in (here it is: Mutual Fund Cash Levels - Adjusted for Inflation).

In any case, right now, this ‘rate adjusted’ model is smack dab in neutral territory. Not helpful at all. It was moderately bullish at the spring low but since then, as the market has improved and as sentiment has thawed, this indicator has backed off into ‘no man’s land’.

NYSE Free Credits
You’re probably familiar with Margin Debt levels, which measure the level of liability in brokerage accounts. Free Credit statistics in contrast, reflect the available, free and clear cash that investors are holding in their trading accounts. This data is released regularly by the NYSE and shows how much liquid assets are held in aggregate by clearing firms overseen by the NYSE.
Continue reading ‘Mutual Fund Cash Levels & NYSE Free Credits’

Last Thursday, Barry Ritholtz wrote in The Big Picture about two data points sent in by Doug Kass:

• The cash positions in mutual funds stand at 3.8%, slightly below the 3.9% low established in 1972.

• Margin debt as a percentage of the S&P market cap has climbed to 2.4%, an all-time high. The previous peak? Early 2000, at the height of the Internet bubble.

While Kass is a blisteringly smart guy, his penchant for the bearish side is well known. So to balance things out a bit I’d like to offer a few counter points delivered by Jason Goepfert from SentimenTrader.com

Mutual Fund Cash Positions
Since Goepfert won the 2004 Charles H. Dow award for his paper on mutual fund cash levels, he is a real authority on this topic. To read it, click on the Dow Award folder within the free trading resource box.

According to the paper, we have to normalize the mutual fund cash levels to account for varying interest rates over time. When interest rates are high, mutual fund managers have an incentive to maintain high cash levels because they are compensated for it. So Goepfert models the theoretical cash level for every interest rate point.

However, having normalized cash levels we still find that right now, mutual fund managers are holding about 3.38% less cash than they should be (theoretically for this interest rate level). It may not be that bearish though. For one, if we see a reduction in the Fed rate, it will reset this indicator. Also, a low cash level can be explained by structural changes in the mutual fund industry.

As indexing has grown, it has taken a larger and larger percentage of assets. Since by definition an index can not hold any cash, this can skew the data. But in reality it only reflects a trend towards indexing (and closet indexing).

Another possible explanation is that charters for mutual funds only allow the manager to hold a certain level of cash and in essence, forces them to invest the rest in equities. As well, with the implementation of new technologies, asset managers can now see fund flows in almost real time, allowing them to react quickly to redemptions and not requiring them to have a cash cushion.

To be totally honest though, while valid, these alternative explanations are rather weak. This indicator is quite accurate in the long term and because of that, it does bother me when I see it at such extreme. What Goepfert argues is that it may not be as extreme as it looks.

Margin Debt
When NYSE margin debt overtook the 2000 levels, many bears made a huge deal out of it. However, this data point must not be taken so superficially.

Goepfert points out a little known statistic: apparently the NYSE not only keeps track of how much margin is being used within brokerage accounts but also how much available cash is there. It is important to note that these cash levels exclude the cash generated by short sales - so what is reported is cash that is owned, unrestricted by the account holder.

Interestingly, when we look at cash level, we see that, as a percentage of market capitalization, it is around 16% now. That’s double from 8% at the 2000 bubble top.

The point is that while margin debt relative to market capitalization is high now, investment account holders have in fact much more cash than they did during the top. This represents a huge amount of real buying power that can drive the market much higher as the cash is put to use.

That potential buying power simply was not there seven years ago.

Classic
This is classic Goepfert. He takes what is seemingly obvious, drills to the core, brings data and hard facts to bear and serves up real insight. Most people start out with a conclusion that ‘feels right’ and cling to the factoids that support their position.

I didn’t reproduce the graphs he provides but they are a thing of beauty. To see them, take a 14 day free trial. Trust me, you’ll stick around on day 15.

It doesn’t matter if you’re daytrading or watching the grass grow on your 401k, as long as you’re serious about making money in the market, Jason’s insights are a must.

One of the eternal battles within technical analysis is the relationship between price and volume. Some argue that volume is not important at all. Especially when different exchanges have different methods for calculating it and different market data sources provide slightly different volume data.

Others have gone so far as proclaim the relationship between price and volume to be the ‘holy grail’ of trading. There are many indicators which incorporate volume. The most popular is the On Balance Volume (OBV) invented by Joe Granville. It is a straightforward indicator which adds today’s volume to yesterday’s if we’ve had a higher price, subtracts today’s volume from yesterday’s if we’ve closed lower and nothing if price was even.

The winner of this year’s Charles H. Dow Award is another indicator that incorporates price and volume but in a much more complicated way. The paper was written by Buff Pelz Dormeier, an executive and portfolio manager with Wachovia (WB).

I’ve put Dormeier’s paper in my ‘goodies box’ - look for the Charles H. Dow Award folder. You can also find the other Dow Award winners there, as well as a whole bunch of other interesting articles, reports and even whole trading books.

I’ve read the paper but not fully digested it yet. At first glance it looks to be interesting but doesn’t provide the same Eureka! insight into the markets that previous Dow Award papers have.

I’ve been meaning to write a review of Jason Goepfert’s website, SentimenTrader, for a while now. I’ve used them myself and referred to their analysis before. If you’re unfamiliar with it, SentimenTrader is basically a one stop shop for actionable technical analysis. The name of the site is a bit misleading since it goes above and beyond simple sentiment measures and keeps track of a dizzying array of indicators and data. If you’re really into technical analysis, SentimenTrader is your wet dream.

Goepfert has been a trader for around 10 years and before worked in the operations department of a large hedge fund. But his credibility as a technical analyst was cemented when he was awarded the 2004 Charles H. Dow award for his analysis of mutual funds cash reserves(pdf) as an indicator of market performance.

What attracted me to SentimenTrader was their focus on actionable analysis rather than just research for research’s sake. You can find a lot of insightful commentary nowadays from various good sources. But almost none of it is really going to help you make money as a trader. That’s what sets SentimenTrader apart. No matter what your style of trading, it is helpful to have a guide that can give you a better understanding of the trend and point to areas where it has a high probability of changing.

The other reason why I like Jason’s site is that he is an inexhaustible fountain of ideas. Sometimes it seems he has one a day! Anyway, he methodically researches every single one and if it survives scrutiny, shares it on the site. I suppose that’s how he has come up with his numerous proprietary indicators. Unlike many though, he doesn’t just blindly follow an indicator but instead picks it apart to get to the underlying concept. And he is ruthless in discarding indicators when he notices that they stop working.

To see some specific examples of what I mean, check out Goepfert’s contributions to Minyanville. Or register for a risk-free 2 week trial.

The only criticism that I can offer him would be to improve the design and user friendliness of his site. The look of the site simply doesn’t match the caliber of information it contains and it may turn away some who ‘judge a book by its cover’.

Very soon (hopefully tomorrow) I’ll have a special announcement related to SentimenTrader which you won’t want to miss