Investors can learn a lot about the securities markets if they understand the dynamics that occur at an auction.  When an auction has very few people in attendance (or there is limited cash available to purchase the items on auction), prices tend to be depressed because of a lack of competitive buying.  On the other hand, when an auction has a large number of people in attendance, prices tend to be higher because there are more people to bid on items.  In other words, in order to have an investment rise in price, one needs to have buyers willing to pay a higher price.  You need more demand – i.e., more cash.  How does this work in the markets?

At the beginning of 2000, when the tech boom began to bust, a significant contributor to the descent in the market indices, in particular the Nasdaq, was a lack of cash to invest in technology stocks.  A way of identifying this lack of cash was the large percentage of assets in Fidelity Select funds that were invested in technology – more than 90% of all the money in those funds.  The money was already there!!

The time period following the great recession is another example. During 2009, we consistently asked the mutual fund companies what types of investments other investment advisors were making for their clients.  For the most part, we were told other advisers had anywhere from 25%-50% of their client’s money invested overseas, with half of those investments in emerging markets.  If you recall, the prevailing financial news at the time was that America was in decline and Brazil, Russia, India, China and South Africa (“BRICS”) were the new place to invest your money.  We constantly asked ourselves, if all the money is in the BRICS, who is going to buy it from us in the future?  In both of these scenarios, the “hot” investment performed very poorly over the next several years.

Today, we see several signs that have us considering whether there is enough available cash to continue to push this eight year-old bull market higher.  Cash on hand with mutual funds is at just under 3% of assets – the lowest level since 1955.  The ratio of cash to total assets in retail accounts is at a historic low of 2.49%.  Pension fund cash levels are also at an historic low of 3%.  Not only is cash low, but margin debt (people borrowing money to buy stocks) is at an all time high (see chart below).  These stats beg the question – “Where is the new cash going to come from to propel the market higher?”

Conversely, because there are fewer buyers in the stock market  “auction”, any correction could be compounded.  Why?  If investors start to sell mutual fund holdings, there probably would not be enough cash on hand to meet the redemptions.  This would force mutual funds to sell securities.  Indexed funds (ETF’s and mutual funds) are always fully invested and any redemption will cause forced selling.  As an increasing amount of money has been going into index funds, those investors likely do not understand this risk if the market corrects.  Add in historically low levels of cash elsewhere, and this could be a recipe for market dislocation.  Could the push by the financial industry into index funds be creating the next Black Swan?

What does this mean for your portfolio?

We continue to be underweight US stocks with an overweight to uncorrelated investments (hard assets, managed futures and long/short fund).  At the end of 2009, we had no exposure to the BRICS, where we have an overweight today.  Being in an underinvested sector tends to lead to outperformance in the future as cash moves into those sectors.  Our disciplined approach of considering the upside return versus the downside risk has helped us avoid emotional investment decisions that have hurt many investors.