Cash levels grow as funds wait to deploy

It does not pay a dividend or a decent savings rate - but cash is the flavour of the moment for some bearish investors as they increase their hoard of hard currency in anticipation of a market sell-off.

With stock and bond valuations at a 12-year high, according to Bank of America Merrill Lynch's global fund manager survey, and the US Federal Reserve contemplating its first interest rate increase in a decade, these investors fear the rally in equities and bonds may be about to come to an inglorious end.

As April draws to a close, such thinking looks timely. US and eurozone equities are pulling back, while government and corporate bond prices are also under pressure. While the present weakness may well prove temporary, patient investors with cash stockpiles are anticipating a pronounced downdraft in asset prices that presents them with an attractive buying opportunity.

Marcus Brookes, head of multi manager funds at Schroders, says: "We want the flexibility to put money to work quickly once bonds begin to weaken. When the Fed starts increasing rates, the bond market could get quite volatile."

Mr Brookes has a 28 per cent cash allocation in his flagship multi-asset fund, an extremely overweight position.

Ben Whitmore, who manages one of Jupiter's main equity funds, says: "I'm not saying we are in a similar position to early 2000 just before the market crash. But when you look at the high valuations, then future returns look low. I would prefer to pause and keep some cash."

His special situations fund has a cash allocation of 10.2 per cent, which compares with a cash allocation of 4 per cent in 2009, when the market troughed and valuations were cheap.

He uses the Graham and Dodd method for valuing stocks, which he says provides a sensible guide to the direction of the equity markets. "Graham and Dodd is a good way to navigate. It is not perfect, but research shows that it is the only measure that has a correlation with future returns."

The Graham and Dodd method uses average earnings over 10 years to provide a price earnings multiple, which accounts for cyclical factors and longer-term patterns in the markets. This PE ratio is 27.8 in the US, significantly above levels of just over 10 in 2009 when equities hit rock bottom in the recent cycle.

However, holding higher levels of cash is a risky strategy. Every day that passes is another one lost when money could be invested in higher returning assets. There are still comparatively juicy dividends and yields in both equities and some corporate bond markets.

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He points to the Bank of America Merrill Lynch survey of more than 300 global fund managers, which shows that average cash levels are at 4.6 per cent. Bank of America's interpretation is that anything higher than 4.5 per cent is a buy signal for equities.

This gauge has worked well since the "taper tantrum" in May 2013, when the Fed raised the prospect of an end to quantitative easing. Global stocks are up more than 20 per cent since then, says Bank of America.

Two funds have struggled since the start of the year, partly because of high cash levels. They are Investec's UK Special Situations fund, run by Alastair Mundy, and the GAM Star Dynamic Global Bond fund, run by Tim Haywood.

Mr Mundy, a contrarian equity investor with a cash holding of 12.2 per cent, is trailing both his benchmark and sector over the past three months with returns of 5 per cent.

Mr Haywood, who invests in fixed income across the board from sovereigns to high yield and has a cash level of 14 per cent, is returning a negative 1.37 per cent.

Although long-term performance is what matters, both fund managers could come under pressure if they fail to improve their returns.

Bill Eigen, at JPMorgan Asset Management, is another fund manager with high cash levels. He has 37 per cent in his flagship fixed income fund.

He admits hoarding cash is a gamble. But he adds that rewards for investing in markets where $2tn of bonds are trading at negative yields are minimal.

He agrees with Mr Brookes, saying the time to deploy cash may be when the Fed raises rates, assuming this shakes up the market and sparks a sell-off.

But until then, cash looks likely to remain king.

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