Mutual Fund Cash Levels and Household Deleveraging
(October 1, 2010)
Dear Subscribers and Readers,
Long-time subscribers may remember a time when my writing was smoother, clearer, and crisper. I admit—the quality of my writing style has certainly deteriorated ever since I started my three-year quest for a joint MBA/MPP (Master of Public Policy) degree at UCLA. Unfortunately, it is near impossible to write well or to be creative when one is just sleeping 4 to 5 hours a day over any stretch of time. The business school environment also poisons and stifles creativity, especially when it comes to that in the financial area. Interning at a long-short equity hedge fund did not help either.
I am now making amends. I began the first of my creative writing class at UCLA Extension yesterday. UCLA Extension has a great writers program taught by published authors, screenwriters, and poets. In fact, many of my classmates (I felt a little bit intimidated) have already written/published scripts and children's stories—if not read and write on a regular basis. Sure, I still have a hectic academic schedule this quarter—and I have yet to start my new hedge fund internship. But the creative writing class will serve two vital roles—first, to get my “creative juices” flowing again, and second, to increase my “writing energy” level to new heights (my writing skills probably peaked in my freshman year of college). More encouragingly, my new hedge fund internship will allow me to be more creative—as its (proprietary) strategy will be unlike those of most other (more “mainstream”) hedge funds. More details to come in a later commentary!
The stock market is now very overbought in the short run, but with our long-term technical trends steadily improving, the longer-term outlook remains bright. That said, there are still (as previously mentioned) various “overhangs” that could derail the current rally. For example, our liquidity indicators remain in the doldrums. The ratio of total checkable deposits plus money market funds vs. the S&P 500 market cap is near cyclical bull market lows. In light of the September rally (+8.92% total return on the S&P 500), there is also a chance that the Fed may postpone or even scrap its proposed “Quantitative Easing II” policy. Moreover, the Bank of Japan hasn't intervened in the FOREX markets (by effectively printing Yen and dumping it on the market) in two weeks. In other words, our main liquidity indicators are nowhere close to turning bullish.
The lack of strength in our liquidity indicators is also exemplified by the percentage of cash in equity mutual funds. In particular, cash as a percentage of equity mutual funds' assets (at 3.5%) remained near its all-time low (3.4%) as of the end of August, as shown in the following chart:
Note that the current reading of 3.5% matches the low of 3.5% in July 2007—near the peak of the last bull market. Given the 8.92% rally in the S&P 500 and the lack of cash inflows into equity mutual funds in September, the buying power of equity mutual funds will no doubt have decreased in September. In fact, I would not be surprised if cash levels at equity mutual funds declined to its all-time low as of the end of September. We will continue to take a wait-and-see approach to the markets. However, should the major indices (Dow Industrials, Dow Transports, and S&P 500) all make a new cyclical bull market high, we will have to honor this technically bullish signal and shift to a 100% long position in our DJIA Timing System.
I now want to digress a little bit and discuss the trend of deleveraging U.S. household that we last discussed in our September 19, 2010 commentary (“The Implications of Quantum Computing and 2010 2Q Flow of Funds Update”). As mentioned, I still expect US households' balance sheets to continue its deleveraging process (as consumers adept to a more frugal lifestyle, and as banks and credit card companies restrict lending). I personally do not buy PIMCO's “New Normal” view of a ten-year deleveraging process, although US economic growth should remain below trend for the next few years. But the inevitability of Schumpeterian growth will no doubt take over US economic growth again. The commercialization of the quantum computer is one example. Not only will this itself accelerate U.S. productivity—but would also directly lead to the commercialization of the next generation of energy, biotech, and nanotech innovations—which in turn would accelerate innovations in quantum or Biocomputing technologies. The combination of this Schumpeterian growth and relatively clean U.S. household balance sheets will drive the next secular bull market in U.S. stocks. I expect the next secular bull market to begin sometime in the 2012 to 2015 timeframe. While the ongoing deleveraging wasn't clear in the 2Q 2010 Flow of Funds data, there is obvious evidence that U.S. households are saving and paying down their debts. This is clear in the most recent trends in US households' financial obligation ratios (ratios of debt payments to disposable incomes), as illustrated in the following chart:
While the above chart signals that the deleveraging in the broader US economy should continue, it also suggests that we have probably finished the most painful adjustments. Going forward, I expect U.S. households to deleverage through a combination of higher disposable incomes (the unemployment rate has most probably peaked), higher savings, and as lenders work through its backlogs of foreclosures and loan defaults (although I expect U.S. housing prices to remain in the doldrums for years to come). Furthermore, as U.S. households continue to pay down their debts and become more productive through technological innovation, “workforce re-education” and starting new businesses, we should experience an improvement in the long-term health of the U.S. economy and society.
Henry To, CFA