Can Sidelined Cash Cause a Blow-Off Top?

I've been having an interesting debate with a friend who runs a long/short tech fund lately. He's been -- quite appropriately -- bullish since August. I got bullish a few weeks before him in July, and wound up being early by two weeks. I then throttled back in mid-September, and suggested getting bullish again in late October.

Most recently, my friend has been easing off the gas a bit, scaling out of long positions into the recent rallies, while I have been advising to buy the dips. Where our thinking -- and therefore trading -- diverges is in our views of the amount of cash on the sidelines.

Undeployed capital is a double-edged sword: Too much cash leads to better-than-the-indices performance when the market is sliding; in a bullish environment, however, a 25% cash position is quite a drag on returns.

Anecdotal evidence explains why I am so confident about the amounts of undeployed capital in the hedge-fund community. If there were a way to quantify this issue, I suspect I would be enjoying crab cakes and another black-and-blue porterhouse at his expense. (We often make good-natured bets about market-related matters; the most recent one, on a small-cap stock, cost him a steak dinner at Del Frisco's.)

Over the years, I've advised managers of institutional cash regarding my broad perspectives on the macroeconomy and markets. Typically, these funds have their own models -- GARP, value, etc. -- and do not focus on the bigger picture. The better funds tend to "stick to their knitting" -- focus on what they do best -- while soliciting input from a variety of analysts and strategists in the areas outside of their expertise.

But lately I have been observing that many of these funds have been looking to deploy cash outside of their own models or strategies. Quite a few of them have been inquiring about throwing off capital to outside managers or strategists, and anecdotal evidence suggests the rise of these "alternative investments" has led to overcapitalized hedge funds.

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to [e-mail].