What a low US mutual fund cash holding could mean

Mutual fund cash holding is usually the lowest at the peak of stock market indexes. So with only 3.6% of their asset in cash, could we be close to a top?

The following graph represents the S&P 500, in orange, versus cash holding, in white, inverted:

It definitely shows a sharp decrease from the “top” of March 2009, where 5.7% of mutual fund assets were in cash. It is a direct consequence of the ultra low return on cash, which gave strong incentives to money manager to “find” investments, and its corollary, a quick return of investors’ risk appetite.

This current level, 3.6%, has usually been associated with a high risk tolerance, which itself precedes major market tops. So in term of risk appetite, this indicator suggests a top could be close.

However, cash level seem to be trending lower since 1993, and we could imagine reaching a new low before a new top, especially since return on cash is litteraly zero.

Consumer confidence

This morning te conference board consumer confidence number came lower than expected, at 46 vs. 55 expected (bloomberg survey).

“Stock market down, confidence down” I read somewhere… Probably. Those two data should have some level of correlation, as they are both related to the underlying strength of the US economy. Also, the wealth effect of increasing stock prices should have some impact on the American households confidence level:

Now the best correlation remains – very logically – with the US unemployment rates. The graph below charts the consumer confidence vs. the unemployment rate (inverted) :

A “valuation” bear market for US stocks

A sideways stock market has some advantage : it improves valuation. If the S&P is pretty much sitting where it was 12 years ago, its valuation ratios have improved significantly. From a high of 5.27 for the price to book and 2.42 for the price to sales for example, they decreased to 2.17 and 1.23 respectively :

This is the real “bear-market”. Even during the 2003-2007 bull market, most ratios did not really expand. They rebounded from the “low” of 2002 and then range-bounded until late 2007. As a consequence, valuation did improved.

So value is in the process of coming back. We might not have seen the low, but we came a long way.

Also, as a side note, the ratio of book value to sales has steadily been increasing, from a low below 0.37 to now a high above 0.57. Which means companies’ book value has been increasing faster than sales. Margins have been trending higher in the last few year, which means higher earnings were extracted from the same amount of sales. As book value comes from retained earnings, we can assume that a large portion of this effect comes from those improving margins. Now, except from a short term bounce due to lay-off and cost cutting, I am not sure this trend will continue.

Bad “good ideas”

Single or double, and now even triple short ETF have become pretty popular. Advantage: they offer new ways to bet on the downside of multiple markets, not always easily accessible. So for small investors, they seem to be a good idea.

And they are… for short term trading. But not for long-term investment. For example, this is the S&P 500 versus SDS, the double short S&P ETF, since August 2007:

S&P 500 : down 25%, SDS : … down 22.5%! Almost as bad!

Worse, it is normal. It is due to the gamma of the ETF. Usually associated with options, this term is appropriate here : when you “normally” short a stock or an index, the variation in US$ of your exposure matched perfectly the variation of the underlying you are selling. For example, if you short the S&P 500 at 1,000, you are short $1,000 (to make it simple). Let’s say the S&P drops by 10% the next day. It’s value is 900, and your remaining exposure $900 (you also have $100 of unrealized profit). In this case, you have no gamma, your exposure varies exactly with the underlying price.

In the case of an inversed ETF and an index at 900, your ETF would be valued at $1,100 ($1,000 + 10% x 1,000). You are now short the S&P 500 at 900 for a net exposure of $1,100, not $900. This increase of $200 is due to the positive gamma, ie increasing short exposure when the underlying moves down. Said differently, you are now short 1.22 time the S&P, rather than 1.

In the case of the double short, the effect of the gamma is even bigger. With an index at 900, you now have an exposure of $1,000 + 2×10%*$1,000 = $1,200. So you increased your short exposure by $300 and are now short 1.33 time the S&P.

Now if the market rebounds by 10% the next day, your simple short ETF would be worth $1,100 – 10% x 1,100 = $990, while the index is only back to 990. So you would have lost 1% while the index would have lost 1%. With a double, you would have lost 2%. Repeat the same process (with smaller daily variations) for a few months and you have an almost certain loosing proposition, even if the underlying goes your way. On top of that, you are getting shorter and shorter as the market moves down, which is exactly at the wrong time, as the probability of a rebound (even just a technical one) increases.

So here again, just for the eyes, the long term effect of a large positive gamma associated with a short position (graph of UHPIX, the double short Hong Kong index, versus its benchmark – inversed) :

PS: This effect is also true with double or triple long ETF.

Correlation between the ISM manufacturing and the S&P 500 year on year return

Recently I came across a few analysis looking at the correlation between the ISM Manufacturing number and the S&P 500 year on year return. Which makes sense as the stock market is impacted by the economy. Talking about stating the obvious…

It is not great, but there are a few points to be made:

– Both series look coincident and major peaks and bottoms happen around the same time.

– The highest S&P returns come from periods of accelerating manufacturing activity (and economy).

– Finally, an contracting ISM Manufacturing number is not always associated with a negative YoY returns for the S&P. You have to have a number below 45 for that.

“Risk is on”

While most asset classes are a few percents off their recent highs, it is interesting to note that risk aversion is back to pre-crisis levels. The VIX for example, is now trading around 20, a low level by any historical measure (although it reached 10 in 2006):

Natixis risk perseption index is also back to historical lows:

So while risk persception is at the lowest level it has been in a few years, it is interesting to note that most asset classes are struggling to make new highs. WTI, Eur, S&P are all a few percents off, and have been trading a range for a while. November soon off the table, it is (according to most analysts) time for the year end rally to lift all boats.

Unless this trade is overcrowded… Which could be the case; at the same time operators start to secure their year end bonuses, taking some chips of the table. So the next few weeks could interesting, giving us a clue weither or not we made a intermediary top.

Natixis on “Moving bubbles”

Natixis recently published an interesting paper on a new type of rapidly moving bubbles. (Unfortunately I can’t find it anymore). But the main idea is that the world liquidity is now growing at a faster rate than before the crisis, while the world has already large excess capacities (in production, real estate, …). As a consequence money is not invested into additional capacity, but into existing assets. At the same time risk aversion is retreating.

So this combination of high liquidity, reduced investment base and low risk aversion is going to create bubbles, which will move from asset to assets, as valuations get rich and momentum wane.

In the first phase, liquidity was in going into US treasuries (recycling of commercial balances) and emerging markets. But as prices increased significantly, valuations got less attractive. At the same time some countries, worried by the inflow of speculative money, are raising taxes for foreign investors (like in Brazil for example).

So in a second phase, liquidity could push commodities higher, acting as an investment proxy. [This has probably already happened as commodity prices, as well as commodity related equities and currencies have already enjoyed very large gains]. Until momentum wane.

According to Natixis, the third step could be for the liquidity to flow into American and European equities, “for the wrong reasons”.

While I like the concept of “moving bubbles”, I have some trouble imagining that both European and American equities enjoying bubble style valuations any time soon; even as a consequence of a high level of liquidity looking for homes. It is more likely that we will see high prices volatility around emerging markets, commodities and commodities related equities and currencies, with some kind of long term trend moving higher. At least until the Chinese miracle is debunked (cf. a later note).

US Nominal GDP in Gold term

In its latest GBD report, Marc Faber used Gold as deflator of the nominal US GDP, effectively creating an index tracking the US GDP in gold term.

As we can see below, the results are pretty interesting:

The GDP / gold ratio is moving in long term waves or trends, which coincide pretty well with real economic growth (uptrends) and nominal growth (downtrends).

As an aside I also looking at the GDP/gold ratio versus the US unemployment rate:

It is not perfect, but high GDP / gold ratio tends to coincide with low unemployment rate.  It seems to make sense as high unemployment also means low GDP growth, high federal deficit and low interest rate… which can be seens as a good combination for gold.

Another divergence

Since the beginning of this rally, economic surprises and asset prices were moving in tandem, meaning that good “surprises” were lifting prices. Since late October, economic surprises have been mostly negative, but most asset prices have continued to rally.

As an example, here is the Citigroup economic surprise index versus S&P 500:

and versus the CRB index:

It is interesting to see that the nature of this rally is changing, now totally disregarding bad news. Could it be a sign that we are entering into the last leg of this rally, ie. the melt-up phase?

Bloomberg professional confidence index

This graph shows the Bloomberg professional confidence index (for north america economy), versus the S&P 500 (in value):

and versus the S&P 500 (Price Earning ratio):

There is unfortunatly not much history, but it already tells an interesting “story”: the current increase in stock price is mostlty due a strong confidence recovery, which lead to a strong PE expansion; and not really an earning recovery.

So unless fundamentals catch up in the next few weeks, we could see a abrupt confidence drop, leading to a sharp market decline. Although, a year-end melt-up rally could postpone this event into Q1, 2010.