Safety, Liquidity, Or Return. Why Cash Is An Important Hedge.
Over the past few months, we have been writing a series of articles highlighting our concerns of increasing market risk. Here is a sampling of some of our more recent posts on the issue.
- Navigating A Tech Bubble (& Living To Tell About It)
- Looking For A Sellable Rally To Reduce Risk
- 15-Bullish Beliefs (Or Not) About The Market
- This Is Nuts…Again. Reducing Risk
The common thread among these articles was to encourage our readers to evaluate the current market “risks” and take some relevant actions. To wit:
“There remains an ongoing bullish bias that continues to support the market near-term. Bull markets built on “momentum” are very hard to kill. Warning signs can last longer than logic would predict. The risk comes when investors begin to “discount” the warnings and assume they are wrong.
It is usually just about then the inevitable correction occurs. Such is the inherent risk of ignoring risk.
In reality, there is little to lose by paying attention to “risk.”
The current deviation between the stock market, the economy, corporate profits, and earnings suggests something isn’t quite right.
“While the rally off the March lows has been substantial, there is still a vast disconnect between the markets and the underlying economic fundamentals. Given the divergence was driven by unprecedented monetary policy, the eventual reversion could be climatic.”
Equity prices are currently outpacing expectations for near-term profits, forming a price-earnings melt-up akin to what was seen in the late 1990s. Furthermore, the S&P 500’s price-sales ratio is also flashing a similar warning.
The Difficult Part
Despite many clear warnings that suggest that current risk outweighs the reward, investors fail to act due to the “Fear Of Missing Out.” (aka FOMO) I recently received an interesting email which makes this point clearly:
“The market is going higher and will continue to do so indefinitely, as long as the Fed is injecting liquidity into the market. If you are removing risk, you are missing out.”
As stated above, the most significant risk to investor capital is “ignoring the risk”.
Just because you see a bear in the woods, and choose to ignore it, doesn’t mean it will ignore you.
“The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a ‘topping process.’ As the saying goes, a market-top is not an event; it’s a process.” – RIA
It’s Your Brain
There are several psychological factors which make managing risk extremely difficult:
- Investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late-cycle stages.
- The “herding” effect ultimately drives investors. A rising market leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.
- Lastly, as the markets turn, the “disposition” effect takes hold, and winners are sold to protect gains, but losers are held in the hopes of better prices later.
In our portfolio management practice, technical analysis is a critical component of the overall process. It carries just as much weight as the fundamental analysis. As I have often stated:
“Fundamentals tell us WHAT to buy or sell. Technicals tell us WHEN to do it.”
Currently, our analysis suggests there is a deteriorating technical backdrop, combined with our outlook for continued disappointment in earnings and corporate profits recovery.
Such suggests that we reduce equity risk modestly, and further increase our cash hedge, until there is more “clarity” with respect to where markets are heading next.
This brings me to the most important point.
The 3-Components Of All Investments
In portfolio management, you can ONLY have 2-of-3 components of any investment or asset class: Safety, Liquidity & Return. The table below is the matrix of your options.
The takeaway is that cash is the only asset class which provides safety and liquidity. Obviously, the safety comes at the cost of return. This is basic.
But what about other options?
- Fixed Annuities (Indexed) – safety and return, no liquidity.
- ETF’s – liquidity and return, no safety.
- Mutual Funds – liquidity and return, no safety.
- Real Estate – safety and return, no liquidity.
- Traded REIT’s – liquidity and return, no safety.
- Commodities – liquidity and return, no safety.
- Gold – liquidity and return, no safety.
You get the idea. No matter what you chose to invest in – you can only have 2-of-the-3 components. Such is an important, and often overlooked, consideration when determining portfolio construction and allocation. The important thing to understand, and what the mainstream media doesn’t tell you, is that “Liquidity” gives you options.
I learned a long time ago that while a “rising tide lifts all boats,” eventually, the “tide recedes.” I made one simple adjustment to my portfolio management over the years, which has served me well. When risks begin to outweigh the potential for reward, I raise cash.
The great thing about holding extra cash is that if I’m wrong, I simply make the proper adjustments to increase the risk in my portfolios. However, if I am right, I protect investment capital from destruction and spend far less time ‘getting back to even.’ Despite media commentary to the contrary, regaining losses is not an investment strategy.
8-Reasons To Hold Cash
1) We are speculators, not investors. We buy pieces of paper at one price with hopes of selling at a higher price. Such is speculation in its purest form. When risk outweighs rewards, cash is a good option.
2) 80% of stocks move in the direction of the market. If the market is falling, regardless of the fundamentals, the majority of stocks will decline also.
3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb, each believed in “buying low and selling high.” If you “sell high,” you have raised cash to “buy low.”
4) Roughly 90% of what we think about investing is wrong. Two 50% declines since 2000 should have taught us to respect investment risks.
5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this.
6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also merely transfers the “risk of being wrong” from one side of the ledger to the other. Cash protects capital and eliminates risk.
7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that without cash you can’t take advantage of opportunities.
8) Cash protects against forced liquidations. One of the biggest problems for Americans is a lack of cash to meet emergencies. Having a cash cushion allows for handling life’s “curve-balls,” without being forced to liquidate retirement plans.Layoffs, employment changes, etc. are economically driven and tend to occur with downturns that coincide with market losses. Having cash allows you to weather the storms.
Importantly, I want to stress that I am not talking about being 100% in cash.
I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.
With the political, fundamental, and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important.
Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop, reviewing cash as an asset class in your allocation may make some sense.
Chasing yield at any cost has typically not ended well for most.
Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.