Keep a close eye on institutional cash

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I find the assets of institutional money-market fund, published by the Fed on a weekly basis, an extremely useful tool in determining the direction of the U.S. stock market. Institutional money-market funds comprise approximately 65% of all money-market funds but to focus on liquidity in terms of value per se may be misleading, though, as the asset allocation including liquidity of retirement funds is highly regulated. The actual liquidity of regulated funds in terms of value is therefore likely to grow in line with the overall value of retirement funds in rising stock markets.

Although not scientifically correct, I express the institutional money-market funds as a percentage of the total U.S. stock market capitalization as represented by the Wilshire 5000 Price Index as a proxy of total institutional funds to get a better picture of institutional fund liquidity, and named it the institutional liquidity ratio. In the graph below it is evident that the liquidity ratio remained virtually unchanged from 1991 to end 2000, meaning that liquidity moved in line with the broad stock market. Since the end of 2000 the face of fund management changed as five major events rocked investors: 1) the ICT bubble finally burst; 2) 9/11; 3) U.S. corporate scandals; 4) the housing bubble; 5) Lehman/great financial crisis. The events in 1, 2 and 3 took the liquidity ratio to 15% while the Lehman Saga and the subsequent global financial crisis saw the liquidity ratio peak at 35%.

Sources: FRED; I-Net Bridge; Plexus Holdings.

The value of the liquidity ratio lies in its smoothed annualized growth rate that is calculated by using linear smoothing − similar to how I estimate ECRI in calculating the smoothed annualized growth rate of the WLI.  When the growth rate surged in the third quarter of 2000 it indicated a change of heart by fund managers as they upped their liquidity at the cost of stocks, resulting in the ensuing bear market in stocks. When they slashed their liquidity levels in favor or stocks in the second quarter of 2003 it happened to be the bottom of the market. In 2006 the first warning signals appeared as the growth rate of the liquidity ratio turned positive. In the fourth quarter of 2007 the growth rate of the liquidity ratio jumped as institutions again favored liquidity ahead of stocks. When the growth rate of the liquidity ratio turned negative again, indicating that institutions were again favoring stocks, the downtrend in the S&P 500 since the start of 2008 was finally broken. It is also clear that the institutions have favored equities ahead of cash since then, except for a slightly positive move in the liquidity ratio’s smoothed growth in October last year.

Sources: FRED; I-Net Bridge; Plexus Holdings.

At this stage it is evident that despite calls from some of my fellow commentators that another bear market is in the offing, the institutions continue to favor stocks ahead of cash.

What I find most interesting as well is that the smoothed annualized growth rate of the liquidity ratio is more reliable than the WLI smoothed annualized growth rate. The liquidity ratio did not give the same false calls in 2010 and 2011 as the WLI did. To my mind the liquidity ratio is a comprehensive indication of institutions’ feeling towards all risk markets, while the WLI is probably a fixed weighted index of the risk markets and does not necessarily reflect institutions’ attitude towards risk assets.

Sources: FRED; I-Net Bridge; Dismal Scientist; Plexus Holdings.

I always wondered what following Robert Shiller had with his PE10 that is based on 10-year trailing earnings. Well, the following graph says it all.

Sources: FRED; Robert Shiller; I-Net Bridge; Plexus Holdings.

It is noteworthy that the liquidity ratio started to increase many weeks before the stock market’s rating was slashed at the start of 2008. That is because the institutions watch the Conference Board’s Consumer Confidence Index very closely and adjust their liquidity ratios according to the main indicator of the underlying economy! (Please note the reverse order of the liquidity ratio in the graph.)

Sources: FRED; I-Net Bridge; Plexus Holdings.

My conclusion is not to call a bear market at this stage. It does seem that the market is overextended, especially if one looks at the gap between consumer confidence and the liquidity ratio. In a recent article I also warned about the PE10 getting ahead of itself, but we could be in for a prolonged period of an overbought stock market.

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1 comment to Keep a close eye on institutional cash

  • whidbey

    Very interesting, but not much more than intuitive either.

    I mean one must be some place in equities or in cash. So price expectations is the moving force that dictates the allocations? The question is timing, in fact, it is everything. The timing seems to follow not Shiller or ECRI ( those are historical projections), but rather, confidence and therefore expectations ie sentiment about the future.

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