Traders are looking dangerously overconfident

Conventional wisdom says there’s no reason to hold cash when faced with an appealing investment. After all, you’re not making any additional income unless you put that money to work.

To the contrary, cash is an ideal destination for nervous traders — or those who don’t think investment of any sort is worth the risk.

As such, cash holdings are a trustworthy gauge for investor confidence. Bears will hold more cash than bulls, who are more likely to be playing the market. Only when cash holdings reach one extreme or another is there cause for alarm.

That’s where we stand right now.

Institutional investors are holding roughly 2.25% of assets under management in cash, the lowest since at least the start of the eight-year bull market, according to survey data compiled by Citigroup. It marks a significant drop from the quarter ended September 30, 2016, when those same traders held about 7.5% of holdings in cash, the most since 2008.

The large decline in cash holdings shows “investors are chasing the tape and putting money to work,” Citigroup chief US equity strategist Tobias Levkovich wrote in a client note.

Screen Shot 2017 07 10 at 8.03.51 AMCitigroupInstitutional investors are holding the least cash since at least December 2008, which is a sign that confidence is overheating.

The reduction in cash holdings is an interesting twist for a stock market landscape that’s long been buoyed by the presence of money on the sidelines. Throughout the past couple years, bulls have cited that excess capital as waiting to flood back into stocks, pushing the market higher.

With that cash somewhat depleted, the argument holds less water, and a red flag has been raised. In 2000 and 2007, prior to bear market downturns, investors were confidently holding similarly low levels of cash.

Still, it’s not altogether surprising that investors are seizing the opportunity to put cash to work. Major indices have routinely made new highs, even amid considerable geopolitical uncertainty, and previously complacent traders don’t want to miss out on any more of the rally.

So now that earnings expansion is back firing on all cylinders, with the S&P 500 expected to grow profits by 6.3% in the second quarter, investors are finally throwing caution to the wind and chasing stock gains. The only problem with that is eventually cash holdings will dwindle to a level where traders are fully invested.

And then what? At that point, options become fairly limited: they can either take the money back out, or pull cash from other asset classes.

That will be the true test of where investors are the most confident, and it may not be good news for stocks.

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