A crash is coming

Here’s an illustration of mutual fund cash levels.

When can we get the massive move over with and mutual funds go back to sane levels of liquid assets? Mutual funds have had less cash reserves than the 2000 peak (and 2008 for that manner) since October 2009. Most likely it is not going to end well, and only after a serious correction and cash raising by mutual funds, can we start to rebuild again. Perhaps I’m missing something, perhaps the invention of ETFs (including inverse etfs, currency etfs, bond etfs, etc) results in mutual funds using currency etfs instead of cash and hedges, and it’s not considered “liquid” assets even though it has the ability to function as such and hedge against market moves. Possibly, but even so, we still have no reason to have lower cash levels than we did in the 2008 top as many of those instruments existed then. So you see, most likely we could retest the lows. I suspect they hold, but I would watch out for markets that failed to make new highs in 2007, that includes the nasdaq and many foreign markets. The S&P should likely be okay.
I can’t tell you when the crash is going to get here, that is the problem. Long term investors must be on constant watch. Short term investors, and aggressive hedgers as well as traders be looking for setups to emerge to the downside and be looking for an opportunity to short or hedge. That means it is not very prudent to invest a significant portion of your assets at this time. Unfortunately the yield of bonds are also very low, but who knows, they may look high by 2012 or 2013 standards. There’s always time to get more conservative and more room to even ironically get aggressively conservative by using leveraged etfs in bond funds such as the TLT, UBT and TMF.

This is the general model I like to use as a rule of thumb to aim for:
long term defensive contrarian
If mutual fund cash levels are
10.5% or higher
Allocate 25% to bonds/cash/currency and “safe” investments
Allocate 75% to stocks/commodities/risk investments
10%
Allocate 30% to bonds/cash/currency and “safe” investments
Allocate 70% to stocks/commodities/risk investments
9.5%
Allocate 35% to bonds/cash/currency and “safe” investments
Allocate 65% to stocks/commodities/risk investments
9%
Allocate 40% to bonds/cash/currency and “safe” investments
Allocate 60% to stocks/commodities/risk investments
8.5%
Allocate 45% to bonds/cash/currency and “safe” investments
Allocate 55% to stocks/commodities/risk investments
6-8%
Allocate 50% to bonds/cash/currency and “safe” investments
Allocate 50% to stocks/commodities/risk investments
5.5%
Allocate 55% to bonds/cash/currency and “safe” investments
Allocate 45% to stocks/commodities/risk investments
5%
Allocate 60% to bonds/cash/currency and “safe” investments
Allocate 40% to stocks/commodities/risk investments
4.5%
Allocate 65% to bonds/cash/currency and “safe” investments
Allocate 35% to stocks/commodities/risk investments
4%
Allocate 70% to bonds/cash/currency and “safe” investments
Allocate 30% to stocks/commodities/risk investments
3.5% or less
Allocate 75% to bonds/cash/currency and “safe” investments
Allocate 25% to stocks/commodities/risk investments

In a random walk market which you have no real indication where it is going, and believe the behavior is completely random, you would be 50% “safe” and 50% long risk equities (stock, gold, etc) and rebalance to maintain that 50% mix everytime there is an advance in either to throw your balance off. This would bring you a profit after a volatile run once stocks returned to where they started. Since you have an idea of direction when it is near extreme readings, you can start to bet more aggressively in that direction. This is a contrarian indicator so the lower the cash reading, the more cash you should have as it is an indication that a change in direction will occur at some point. There is a reason I don’t follow this model completely and that’s the possibility of hyperinflation, plus the tendency of markets to trend. This is playing against the trend and requires patience. Theoretically we could in fact see cash levels at or near 0 and stocks continue to go higher if the debt increases and credit limits increase. That is a possibility. One way to hedge against this is to use excess cash to buy physical gold, silver, food and maintain physical cash in your house, and that way you can stay protected against the extreme. However, owning even 25% stocks during hyperinflation and holding will really do very well to protect your wealth.

Since this indicator is fairly predictable

You could perhaps wait to shift your allocations UNTIL you reach extremes. Also the direction is important when it is not at extremes. If it is coming from extremely low cash levels, you typically will get lower stock prices until you have that mutual funds raise a lot of cash above say 8%. Additionally, some people may prefer to wait for a change in trend on a monthly chart. We had such a change in August and it remains bearish on a monthly chart.

 

Also, note the similarity to the top at this chart in June of 1937
also note the decline that followed
You should look at the divergences in the slow stochastics and RSI (as the market went higher the readings went lower) and also the break in momentum to the downside as well as the break below the stop in the parabolic sar (stop and reversal)

A weekly chart is bullish at the moment, indicating we could have a month or two where we go higher. However the long term trend remains down and caution is advised along with a cautious mix of stock and bonds. Between August and now (as well as into the future as long as trend remains) is such a period where a 75% bonds, 25% stock mix would (have been and still would) be appropriate.

 

Here’s another look at a comparison

This by comparison is another possibility. the 1998 bottom comparison.

So it’s not as always easy as looking at similar patterns, because there are usually comparisons that make the opposite move. However, by using the long term model based on mutual fund cash levels as a guideline, it seems much more appropriate to use the bearish comparisons since the cash levels of mutual funds were around 5% when it made a bottom in 1998 and the previous decade was mostly a bull market. Also, even though in the example stocks went considerably higher in 1998 a decade later they were in fact lower. So it certainly would have been a good idea to have been defensive and you would have been able to collect a nice yield. You would have still produced gains with the amount allocated towards stocks, and you would have rebalanced to take some profits and reduce the position as stocks did higher and perhaps even reduce the percentage in 2000 as the cash levels  reached 4% so you would have been largely protected against the top in 2000 and rebalancing would allow you to add more to make sure you maintain the 25% or 30% on the way down, possibly even increasing that % at times and you would have rebalanced again on the way up to take profits. It’s a longer term approach, and generally the longer term approach you have, the more likely you are to miss out on major volatile swings during a decade that is sideways, however, although you won’t be positioned perfectly, you will still have exposure to the upside allowing you to rebalance, or exposure to bonds, allowing you to rebalance, and thus you have an opportunity to end up okay.