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Margin Debt & Mutual Fund Cash Levels Don’t Matter at Trader’s Narrative

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

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.

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.

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4 Responses to “Margin Debt & Mutual Fund Cash Levels Don’t Matter”  

  1. 1 Johan

    The mutual fund business is in fact vary different from one or two decades ago. Now many more funds have rules that don’t allow them to hold cash of any significant degree. People that invest in stock funds, are not investering in the fund manager’s ability to manage cash, but how he manages stocks.

    So I don’t think it’s accurate to compare the data longer than 10 years back.

    Have a great weekend!

  2. 2 Bary Ritholtz

    Jason does nice work —

    I have written in the past that increasing margin levels actually are fuel for a bull market, and its not until they spike that it becomes problematic.

    As to cash levels, I am not so sure. Yes, indexing is bigger today than it was in the 1960s. And, plenty of mutual fund firms have mandates to have no more than X% cash. But I am not so sure it can be so easily dismissed.

    As we have seen on the hedge fund side, once redemptions begin in force, it begets a wave of selling . . .

    Thanks for posting the comments

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