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Last week we looked at the levels of cash and free credits being held in institutional and retail trading accounts in the US: Mutual Fund Cash Levels & NYSE Free Credits. I briefly touched on a research report on mutual fund cash levels by Jason Goepfert, who by the way, runs a great service at SentimenTrader. However, I wrote that:
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.
Upon his return, Jason accepted my suggestion and lost no time in whipping up a new indicator which takes into account the added variable of inflation/deflation.
To be able to understand what this new chart is saying, it is helpful to go back to the award winning research report. In it, Jason argues that before we try to use mutual fund cash levels as an indicator, we need to adjust it for the prevailing interest rate environment. For example, in the 1980’s, with interest rates in the double digits, there was ample reward for sitting in cash. Stripping out this effect, therefore, is important because otherwise it is a distortion.
Using statistical modeling, we can determine how much cash should be held by assuming a certain level of interest (90 day T-Bill rate). After that, it is easy to compare the actual cash levels to this theoretical level to determine if mutual funds are overweight or underweight cash. Looked at this way, mutual fund cash levels are neutral, telling us that managers are neither overweight or underweight cash right now.
Alright, so what happens when we also take into account the effect of inflation or in today’s case deflation? In other words, the real rate of interest?
A completely different picture emerges. This isn’t surprising because we are currently experiencing real interest rates close to +6.5% - a far cry from the nominal rate of 90 day T-bills. Here is the inflation/deflation adjusted chart of mutual fund cash levels:
Well that changes everything!
The mutual fund cash level is no longer neutral. This new adjustment shows that on aggregate, mutual fund managers are holding about 1.5% less cash than the statistical model suggests. While that may seem a trifling difference, historically, it has been a tell for a topping market.
The data fits the market remarkably well. The only caveat is that as timing indicators go it is sloppy. The market may top now, a week from now or a bit longer. With the corollary that the amount of cash may decrease even further. But the message of this indicator is crystal clear: the market is top heavy.
If you are interested in further details, you can download Jason Goepfert’s research on mutual fund cash levels from the Free Trading Resource section. Check in the Charles H. Dow award folder. Needless to say, I highly recommend Jason’s work. Head over to his site and take him up on his no risk, 14 day free trial offer.
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