Hedging Your Bets With Matt Davio: European Vacation with Aunt Edna

As we come into what I find the slowest market trading month of the year, I am always reminded of the Chevy Chase movie series with Aunt Edna on the top of the cartop, dead as a doornail. Aunt Edna is very reminiscent of market conditions in August. Considering the big move up the equity markets had in July, I expect the slowdown to hit full force as we come back to the start of the school year and the business year winds down into the final 5 months.

Over the past few years, I've discussed and debated the cash levels of mutual funds on numerous occasions. Each time, I've been adamant that while funds were holding a low cash reserve, their behavior wasn't that unusual given the very low rate of return they were receiving on the cash that they were holding.   No longer!

The latest figures available, through June, show that funds once again reduced their reserve of liquid assets. This is in spite of the facts that June closed at nearly the same price level as May (for the S&P 500) and that short-term rates continued to creep higher. Now many funds are holding about 2% in cash - a very low reserve.  For the market, that means their isn't a lot of “fuel” left to propel the market higher - and 2% is close to the “tipping point” that has led to very poor market performance historically.

The chart below shows the expected rank of forward 12-month returns in the S&P 500 given the level of mutual fund cash levels adjusted for short-term rates. For example, when the rank is 90%, it suggests that 12 months later the S&P 500 will show a return that is greater than 90% of 12-month returns in its history. When it is below 10%, it suggests the forward return will be in the bottom 10% of all returns.  As of the latest data, the expected future return in the S&P dropped to 7%.  That's not exactly encouraging.

Navarro's Broad Market Outlook: Here Today, Gone to Maui

Having gone through a “jobless recovery” for several years following the 2001 recession, we now are about to transit into a “return-less recovery” for the stock market.  At least for the next few months, the risk-reward will favor the short side.    

Why? One reason offered by Matt Davio is that the mutual funds have spent their bullets.  Another is the inexorable rise in interest rates.  Still a third is the oil price shock that hasn't fully hit us yet.

Sure, we could go on with the good times we've been having.  I just don't want to be betting on that at this point.

Portfolio Musings: Penny Ante Stuff

I'm in buy and hold mode now with no new buys, likely until after Labor Day and will trim from the herd as selling rules dictate.  This is the cards I will be holding for the next month or so (but trim as need be).  You will see in the discussion below a portfolio heavily weighted away from highly cyclical industries.

Long: ARDI, ARTX, ASTM, CHIR, PPHM, PRCS, SGI, STEM, SVA, VION, VRSO, ZILA

Closing: IBIS, PDYN

ARTX is a military security play insulated from the business cycle.

ASTM and STEM are long term stem cell plays while PPHM, PRCS, SVA, VION, and ZILA are all biotech plays - all very defensive.

ARDI is a GPS pure play while VRSO is a VOIP play.  Both are exposed to the business cycle but in a bullish industry cycle.   (By the way, I'm in the red on VRSO because the stupid management gave away a zillion stock options to the new CEO - very annoying.)

Peter Navarro is a business professor at the University of California-Irvine, and can be contacted at peter@peternavarro.com. Matt Davio is a managing partner at the hedge fund, Red Rock Capital Fund, and be contacted for hedge fund services at redrock@peternavarro.com.