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Mutual Funds

The Smart Profits Report: Issue #357
Wednesday, September 27, 2006

Mutual Funds: How To Interpret The Actions of Mutual Fund Managers
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research

Imagine a beautiful late summer evening at the state fair. The sounds of children playing on the rides. The wonderful smell of food wafting from every direction. An idyllic scene by any measure.

But what would happen late in the evening if all of the fair-goers ran out of cash? Would any of the rides, or funnel cake stands stay open?

A funny thing happens when buyers run out of money: Commerce grinds to a halt. And after a rapid late summer run, a similar scene is happening in the equities markets right now. The biggest buyers of mutual funds are running critically low on cash. And when this happens, it affects regular traders and investors like us. So let’s see exactly why… and how we can combat it…

Consulting The Mutual Fund Managers Cash-To-Asset-Ratio For Clues

In my research, I’m always looking for “leading indicators” - that is, prominent characteristics that can act as predictors of the market’s long-term direction. And one of the best is the ratio of cash to total assets being held by mutual fund managers.

  • If, as a broad group, mutual fund managers think the market is heading down, they would have less of their funds’ assets invested in the stock market.
  • On the other hand, if they anticipate an uptrend, they would naturally invest more of their cash in the market to take advantage of that.

This is important, because as with most large groups of investors, when too many mutual fund managers start thinking the same way, it’s usually a sign that we’re ready to hit an extreme and head the other way.

So if you want to know how much cash the mutual funds are spending or keeping, one of the most useful ways is to compare their cash-to-asset ratio (simply the amount of cash that is not invested divided by the total assets of the fund) to the rate of a three-month Treasury Bill. This gives us a feel for how much cash fund managers are holding, relative to the opportunity cost of holding cash risk-free.

Simply put, when this ratio is low, managers are extremely bullish. When it’s high, they are very bearish (or cautious). And since the cash-to-asset ratio is a contrarian indicator, when too many mutual fund managers are bullish, there aren’t enough left to jump on the “bullish bandwagon.” The most likely market reaction is to turn toward the bearish side.

For example, in the spring of 2000, mutual fund managers were more heavily invested in the stock market than at any other time since the numbers have been compiled. But predictably, they soon became the least heavily invested in late 2002 to early 2003 - just as the market turned back to the upside.

Where Has All the Cash Gone?

So how do mutual fund managers have their assets deployed now?

  • Answer: The amount of cash being held is approaching the all-time lows that were hit in the spring of 2000! (This is taking into account the interest rate of a three-month T-Bill). This is a very bearish long-term signal for the stock market.

But a word of caution: This is a long-term indicator. This extreme value may take months to play out in the markets. But it would also be a very rare occurrence for mutual fund cash to be so low and not result in the market making a significant correction.

Simply put, the stock market is like the funnel cake vendor at the fair: When the customers don’t have any cash to spend, you can’t sell any deep fried dough.

What To Do As Mutual Fund Cash Drains Away

  • Bottom line: The stock market’s biggest customers, the equity managers, are almost out of cash. So it’s difficult to see where any new money will come from that could fund a sustained stock market rally from here.

But since this scenario takes a while to play out, it’s not quite time to jump ship just yet. However, it’s worth keeping your eyes on other warning signs, and checking to make sure you have a decent exit strategy. A market decline may not happen imminently, but with mutual fund cash levels nearing all-time lows, more caution than usual is called for.

Good Trading,

D.R. Barton, Jr.

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Today’s Smart Profits Cribsheet

  • If you’re looking for clues from the world’s best fund managers, you won’t do any better than PIMCO’s Bill Gross. Check out what Mt. Vernon Research Chairman Karim Rahemtulla had to say about this legendary investor in Smart Profits #201: What Does Bill Gross Know?
  • Also, check out Smart Profits #343, Warren Buffett’s Investing Strategy: The Master of the “Buy and Hold”, in which Karim Rahemtulla talks about Warren Buffett’s investment strategy and what investors can learn from his intentions towards USG Corp.

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The Chart of the Week

The DJIA advances toward it's all time high!

As mutual fund cash levels fall toward all time lows, the Dow Jones Industrial Average advances toward its all time high! However, it’s doing so with slightly declining momentum. Remember, we came very close to making all-time highs in May, only to have the market fall sharply away. A very likely scenario from here is a “prairie dog” top where the Dow pops its head up just above the May highs and then pulls back due to lack of momentum.

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