Cash Is Sending a ‘Sell’ Signal. What Stock Investors Should Do.

Stock traders watch the market on Monday morning. (Michael M. Santiago/Getty Images)

Key Points

• Equity fund managers hold 3.8% of portfolios in cash, down from almost 5% earlier this year, signaling a potential sell-off.
• Bank of America considers cash holdings below 4% a sell signal that historically has preceded drops in the S&P 500 index.
• Investors’ allocation to US stocks is in the 96th percentile over the last decade, indicating high exposure and potential for a pullback.

Portfolio managers aren’t holding much cash anymore, a negative signal for stocks.

Equity fund managers hold, in aggregate, about 3.8% of their portfolios in cash, according to Bank of America, which surveyed managers overseeing trillions of dollars worth of assets. That is down from almost 5% early this year.

When stock prices rise, and managers buy shares, stocks account for a larger percentage of their portfolios, while their cash holdings fall in percentage terms. A decline in cash holdings is a common symptom of a rising market.

When cash holdings drop below 4%, it triggers what Bank of America calls a sell signal. Historical data cited by strategists at the bank show that when the percentage held in cash rises to a certain level, the S&P 500 goes on to gain for a sustained period. When it goes too low, the index usually goes on to drop for a period of weeks or months.

The reason is that when stocks become more expensive and vulnerable to losses, fund managers need a cushion in cash to limit declines in their portfolios. When fund managers’ cash goes low enough, they can’t buy much more stock, and they sometimes have to sell some to raise more “dry powder.”

All of that puts pressure on stock prices, and cash is appealing at the moment, with a risk-free yield of 3%.

Consistent with this, investors’ allocation to U.S. stocks is already almost as high as it is likely going to go. A look at all types of mutual funds and exchange-traded funds from Citi strategists shows that funds’ aggregate allocation to U.S. equities is in the 96th percentile relative to levels over the past decade.

That lines up with the fact that, at the moment, investors already own a lot of stock and not a lot of cash, signaling that selling could soon overwhelm buying in the stock market.

This doesn’t necessarily mean the market is in for a catastrophic collapse, but it does mean it has increasingly been at risk of a pullback, even if it proves to be minor. Traders should get ready by selling stocks, either to raise cash to put to work later or via short sales that bring gains when prices fall. Buying futures and options contracts that increase in value when there is more volatility is another viable move.

Turbulence could hit the market as a result of any number of potential factors. Inflation has remained above the Federal Reserve’s target, which could mean the bank cuts interest rates less than Wall Street expects in the next several months. That wouldn’t help a slowing economy.

And the minute Big Tech companies decide they can significantly slow down their spending on artificial intelligence, a host of companies that build and power data centers would see a hit to their expected sales. Their stocks would suffer, too.

Long-term investors don’t need to sell stocks. Those who have been in the market for years have enjoyed large gains over the past several years, and, brief interruptions to bull markets are normal. Sacrificing exposure to the market because of the possibility of a small drop isn’t the best way to invest, especially because the market may well keep gaining for a long time as a result of continued economic growth. AI growth is still in its early innings, even if it experiences a short-term interruption.

The takeaway for people who are in for the long haul is to avoid buying more stock. Putting new money to work into a market that could drop soon may not make sense; having cash ready to buy any dip is a better strategy.

Don’t be surprised to see that drop come soon.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com