Tobias Levkovich, chief US equity strategist ofCitigroup Smith Barney, recently claimed his panic/euphoria model had moved out of panicand into neutral territory. We're not completely sure how or why the model shifted,given that mutual fund cash ratios were down to all-time lows, or that investment advisorshave been relentlessly bullish for more than two years, margin debt was at levels achievedonly three months before the biggest peak in 71 years, or any number of other indicatorsthat seemed to show a vast proliferation of enthusiasm for stocks. Consider thefollowing; one of Mr. Levkovich's colleagues, Prudential's Ed Keon, had gone out on a limbadvocating a 100% exposure to equities. Obviously, we have no idea what"euphoria" might mean in Mr. Levkovich's model. Although the averageequity exposure of the top 13 strategists quoted each week by Dow Jones is"only" 66.2%, their exposure has ranged very much in the same neighborhoodthrough thick and thin, from before the March 2000 peak, through the peak and every weekthereafter, never falling below 61.5% and rising as high as 70.8%. Truth be told, itis the job of strategists to sell stock, regardless of what might lie in store forprices. Obviously, the big brokers are not well served when customer assets are tiedup in "cash" investments, like the money market and Treasury bills. Likeall publicly traded big companies, the bottom line is a huge consideration and commissionsare best generated when retail clients, pension fund clients and mutual funds buy, buymore, and buy still more. That couldn't possibly infer "euphoria," couldit?
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Jason Goepfert, president and CEO of Sundial Capital Research,Inc., won the prestigious Dow Award last year, confirming studies done nearly a generationbefore by Norman G. Fosback. Briefly, the study “normalizes” the cashreserves of mutual funds by taking into account the current level of interest rates. Theoretically, the lower the level of interest rates, funds are able to accommodate lowercash reserves. However, interest rates have now been raised ten times. Goepfert comments, “The Mutual Fund Cash Premium/Deficit that we post to the site [
If we assume inflows continue to average roughly $11 billionper month—as they have over the past year—we have all the information we need toextrapolate a guess for where the Dow might be in a year’s time if mutual fund cashreserves rise to the 6% level Mr. Goepfert suggests is appropriate given the current levelof interest rates. Bear in mind that funds have spent virtually every penny ofinflows for quite awhile. If they now spend only half and divert half towards cashreserves, prices will fall by approximately 8.7% over the next 12 months. Ifinterest rates continue to head higher, the “correct” level of mutual fund cashreserves would also head higher, thus an 8.7% decline could very well turn out to be aconservative estimate.
As well, the 12-month moving average of reserves isnow at a record low of 4.27%. One aspect of low reserves truly stands out; the Dowhas gone nowhere (actually down) since the longer term measure of reserves bottomed inMarch 2000 at 4.64%. There has been tremendous price resistance with a lower levelof cash reserves and there is no reason to expect that this situation to reverse. Prices for the major indexes will likely remain mired below their recent highs until cashreserves are solidly boosted.
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We still believe a major top is in the process of playingout. The timing could not be more propitious, with our expectation of a typicalsummer high leading into a typical autumn swoon. Mutual fund inflows usually declineinto the summer and into the dog days. Given the April-June period witnessed lowerinflows than the average of the prior 20-years, the propensity of funds to spend even morein their quest to support the averages seems extremely risky. There have been onlytwo times in history when cash reserves were this low and both were major tops that led tovery significant price declines. Although some observers have ignored the low levelsof cash and have instead, excused them as a function of lower interest rates, we can onlycite that this is first time in stock market history that ten interest rate hikes havebeen applauded. Is it different this time? We think not.
Although we have modified our low side targets modestly, webelieve the odds of a 15% to 20% decline are still considerable. In the last twoweeks, there seems to be a very slight pullback in optimism but some measures, such as theInvestors Intelligence poll of newsletter writers, indicates a bizarre extreme in optimismversus some very punk market action. The ratio of bulls to bears is the highestsince December 29, 2004. The Dow did trade about 1% higher in March, but has notmounted any serious challenges since and traded 8% lower the following month. We expectthe current round of optimism to play out far worse and soon.
Although $67 crude has not yet had much impact uponstock prices, we suspect a delayed reaction will provide the volatility we have beenlooking for many months. Our minimum expectation is at least a 10% decline in themajor averages between here and mid-October.
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Equating the housing situation to the bubble that existed (andstill does) in stocks, makes no sense at all. A boom is one thing. A bubble isquite another, as our next chart clearly illustrates, using the last ten years into themania peak, the last decade of gains for housing, and indexing all to a starting value of1. Allegiance to stocks runs a very poor second in relation to the allegiance toone's abode. If housing prices begin to correct to the extent that homeowners arecompelled to raise cash, there will certainly be massive selling of equities from bothpersonal and retirement accounts, rather than a panic to sell homes.
We have no doubt that prices in certain areas aretotally bonkers, particularly in California. But this does not make for a nationwidebubble. WSJ's Neil Barsky recently asked, "What Housing Bubble?," pointingout that "Home prices on average have risen at a 6% annual pace since 1999, and 13%over the past year." By comparison, the S&P 500, fully 80% of the entireU.S. stock market, rose at an astounding 25.4% clip for the five year period leading up tothe March 2000 peak. The latter was a veritable bubble. Comparing housing tostocks just doesn't fly.
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ABOUT ALAN M. NEWMAN
Alan M. Newman has been the Editor of CROSSCURRENTS since the firstissue was published in May of 1990. Mr. Newman is also a member of the Market Technician'sAssociation and has been widely quoted for years by the financialpress, media, and other newsletters and has written articles for BARRON'S.
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