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Cash on the Sidelines Update

(April 1, 2010)

Dear Subscribers and Readers,

In a real-time “Special Alert” email we sent to subscribers on Monday, we noted that we had just shifted our 100% long position in our DJIA Timing System to just a 50% long position for now.  We made this shift at a DJIA print of 10,888, and will provide an update of our DJIA Timing System's performance in this weekend's commentary.  This was done for risk control purposes.  Even though we believe that the cyclical bull market that began in early March 2009 remains intact, we also think that the risk for a significant correction is now at its highest level since the bull market began.  Aside from highly overbought conditions, many of our sentiment and liquidity indicators are also flashing an imminent correction, including the equity put/call ratio (the 10-day MA of the equity put/call ratio has been below 0.55 for the last two weeks), the VIX, and various other pieces of anecdotal evidence (e.g. many folks who did not believe in the bull market in the first place or who have been looking for a correction since last September are now turning bullish).

The short-term liquidity situation also supports that a correction is now almost imminent.  For example, the amount of "investable cash on the sidelines" versus the S&P 500 market cap has come down dramatically since the February 2009 peak, as shown in the following chart:

Total Money Market Fund & Checkable Deposits / S&P 500 Market Cap (January 1981 to March 2010) - At its peak at the end of February 2009, this ratio spiked to a 27-year high 66.27%. There is no doubt that the March 9th low represented a major bottom for the US stock market. Since then, it has declined to just 34.20% - its lowest level since May 2008! This ratio has come down too far, too fast. This author is thus looking for the market to correct over the next 2 to 6 weeks, although the longer-term uptrend remains intact.

As can be seen in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has been making new rally lows consistently since the beginning of this bull market (with only slight pauses in June 2009 and January 2010.  In fact, this ratio plunged by 2.95% in March (due to a combination of a rising stock market and a decline in money market funds outstanding), and is now at its lowest level since May 2008!  While this ratio is still high from an absolute standpoint (especially compared to its historical record from January 1995 to December 2007), it has definitely come down too far, too fast.  Probability suggests that the market will experience a correction right here, unless: 1) A major central bank announces a new liquidity facility (e.g. the Federal Reserve announces an extension of its “credit easing” program), or 2) a major technology (one that could speed up U.S. productivity growth) is commercialized over the next several months (which is not likely).

In addition, the amount of cash as a percentage of total assets at equity mutual funds has just hit a new low as of month-end February 2010, as shown in the following chart:

Monthly Equity Mutual Fund Cash Levels (January 1996 to February 2010) - Aftering spiking to an 8-year high of 5.9% at the end of February, cash levels as a percentage of total assets at equity mutual funds has declined to an extremely low level of 3.5% - its lowest level since July 2007!

The last time that equity mutual fund cash levels has been this low (3.5%) was month-end July 2007 – just two months prior to ultimate peak of the October 2002 to October 2007 bull market and right at the peak of the NYSE Common Stock Only Advance/Decline line!  Combined with the relatively low amount of money market funds + total checkable deposits outstanding, there is no question that this number is way too low – I thus expect a market correction to begin without warning.

Conclusion: While the general global stock market action and liquidity conditions suggest that the cyclical bull market remains intact, there is significant counter-evidence (mostly short to intermediate term) that suggests a stock market correction is now at-hand.  For the most part, I believe any correction that occurs will last 2 to 6 weeks, or until our intermediate term technical/sentiment indicators get oversold.  I do not really have a price target at this point, although subscribers should note that there is strong support in the DJIA 10,000 to 10,300 range.

Signing off,

Henry To, CFA

 

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