There are essentially two major views on cash in one’s portfolio. One view, which is predominantly held, is that cash yields nothing and thus must be allocated into an asset that does yield. The other view is that cash provides the ability to strike when value opportunities arise, and that ability is virtually priceless when the blood is running. What would you have given to have a warchest full of cash to deploy in March of 2003 or March of 2009?
The Spring 2015 edition of Columbia Business School’s (“CBS”) student-led value investing newsletter, Graham & Doddsville, profiled Matthew McLennan of First Eagle Investment Management, the house that Jean-Marie Eveillard built. By the way, Graham & Doddsville is published 3 times a year in the winter, spring, and fall. The newsletter contains interviews with investment pros, highlights of the CBS program, and investment theses by students. It can be a tad redundant of a read, much like Marginrich.com, but every now and then you can glean some quality insight from the interviewees.
McLennan shared some valuable insight on the value of cash, eloquently stating:
We can’t predict what the future will bear. At First Eagle, we view cash as a residual of a disciplined underwriting approach and as deferred purchasing power…We don’t feel the need to force cash to work just because it is a zero-cent yield today, because the return to cash has two components: it has the current yield, and it has the option of redeployment in distress. We feel, given the state of the financial architecture, there will be more windows of opportunity over the coming years to buy businesses that offer potential return hurdles in windows where the markets are less complacent.
It’s this option of redeployment why cash warrants a higher allocation right now. The spectrum of investors is vast with varying risk tolerances, varying asset levels, varying time tables, etc. Whether you’re a professional or an amateur, there is enough compelling evidence to espouse this view. Let’s start with valuations.
Sure, the major US stock market indices are hitting new all-time highs but the price action looks weak, and that’s on the back of some of the highest levels in history of current valuations. Traditional valuation methodologies such as the CAPE and Tobin Q are at levels only seen in 1929, 2000, and 2007. Does that not concern you?
Doug Short provides charts that depicts the CAPE, which he calls P/E 10, and Q plus the Crestmont P/E and S&P 500 regression from its price. One chart that particularly captures the moment in valuations, allowing for some perspective, is the Average of the Four Valuation Indicators with the standard deviations highlighted. Observe:
What immediately jumps out about the chart is that we are currently two standard deviations above the mean for the average of these four indicators, and we are also at a level higher than where we were at right before the Great Depression.
So what! This time is different, right? We’ve got interest rates at basically zero and quantitative easing in Europe and Japan after having just finished in the US. With rates at the zero bound and QE occurring in the most major of markets, equities appear “fairly” valued. Which begs the question, then what is extremis? Is it 10% higher from current price levels on the S&P 500? 20% higher? 30%? Who’s to say? Certainly not the overwhelming majority of professionals. There will be some that nail the top; statistically it’s inevitable. However, the preponderance of evidence unequivocally shows that the professionals are as ignorant about the future of stock market price levels as the people who unfortunately rely on their opinions. They have no idea when the music will stop which is why they keep dancing and dancing and guiding the public to do the same.
Let me provide you with a perfect example. Here’s a December 2007 article from Bloomberg Business(pre-BusinessWeek acquisition, hence the references) titled Where to Put Your Cash in 2008. In it, seven stock market analysts were polled including some from the largest banks on Wall St. The list includes Chief Investment Officers or Chief Equity Strategists at banks such as Citigroup, BofA, and BNY Mellon. Here is where each member of the poll stated they thought the S&P 500 might be trading at by the end of 2008, 1. 1,520 2. 1,675 3. 1,680 4. 1,700 5. 1,675 6. 1,625 7. 1,700; for an average of 1,653.
Anybody recall right off the top of their head where the S&P 500 closed on December 30th, 2008? It was 890. 890!!! Even the most pessimistic of the 7 missed the mark by a whopping 42%. That is egregiously inaccurate for some of the most allegedly well-informed and experienced market forecasters. And what’s worse, these calls were made in December of 2007 well after the market had begun to turn down and create a lower-high. Now of course, hindsight is 20/20 and maybe BusinessWeek excluded any bearish pollings which may have been more accurate, but the fact is these chiefs help in the decision making of multi-billion dollar organizations with multi-billion dollar portfolios.
Many pros utilize statistical models that provide a false sense of security; not just the pros but the academics masquerading as professionals at the world’s central banks and asset management houses, too. They think everything in the world is simply a matter of accurately determining the mathematical expression of potential and probable outcomes. Because as long as you can assess portfolio risk via language like this,
then the world is your oyster. Recall 1998 and the wrench that LTCM threw into the equity markets thanks to its genius partners who could quantify anything and everything in the world so profits were guaranteed. More recently in 2007, every financial house and shop knew risk was mitigated because the statistical models quantitatively guaranteed it. Human behavior simply cannot be accurately quantified with any long-term consistency and the markets consistently forget that. If that were not the case then IBM would be the most successful hedge fund in the world with Watson precisely quantifying all human risk variables and factors to own the world of speculation.
The so-called smart men don’t have any better knowledge of the future than some guy off the street. The future cannot be statistically quantified within an if/then statement. The rationale of the central planners and economists is consistently, “If this then that”, but the world is not tied up and wrapped up so neatly with a bow on it. The same can be said for our economy and financial markets.
People think that the people at the top have all the answers and will provide fair warning for everyone, but that’s not the way it works and people’s incessant memory loss of all things financial prove that out. You don’t know when a component of your car’s engine is going to malfunction. It just happens. Same goes for the economy and the markets. Along will come an unforeseen event i.e. black swan i.e. fat-tail that will critically damage the component of the engine causing the machine to breakdown. Let me remind you, that the same people that stewarded the financial crisis of 2008 are still in power at all the major private, public, and government entities.
I don’t mean the same people in the literal sense, but the same kinds of individuals. All without extra sensory powers of foresight and omniscience. They continue to utilize the same models that have been so greatly leaned on since the 90’s. The kind of statistical models that say “Oh, this event could only occur once in every 10,000 years so we have nothing to worry about regarding the management of our risks.” When the next downturn comes along, and it will because cyclicality is but one of nature’s simple inevitabilities, all these smartest-people-in-the-room types will be poring over their models and wondering how such a deviation from the standard could have caught them unawares.
Don’t be caught in the same trap that ruined the financial portfolios for so many investors on the brink of retirement. Now is the time to prepare yourself, because your RIA or whoever else you entrust your financial future to will not be able to safely shepherd you through the next financial crisis. They can’t. It’s virtually impossible due to career risk, fund charters, and the greed of maximizing assets under management.
There will of course be the small cadre of asset managers that go to cash early by tactically liquidating the portfolio and placing intelligent counter bets to strategically capitalize on the next great dislocation; in the process becoming hailed as new gurus. However, the financialization of our economy has driven so much talent into the markets that it’s statistically impossible for most money managers to not lose big. Inherently, the players in the field know and understand this but the people placing their hard-earned money with these players generally do not share the same level of comprehension.
I’ve been sharing my thoughts for some time now on the potential benefits of raising cash levels. I don’t think it’s alarmist. I continue to think it’s prudence. I’m not saying exit the markets. Just start to build cash levels. Examine the chart below with the obvious benefit of hindsight.
Let us assume the next great dislocation takes the S&P 500 down by 50%. This assumption is based on the approximate haircuts of 47% and 56% in 2000 and 2007, respectively. For the sake of the illustration, let me also generously give the S&P 500 another 30% of upside from current levels. That would put the S&P 500 at about 2,770. Halve it and you have 1,385 which is still 35% lower from current levels, a bear market by any standard but the 50% markdown would be avoided for a portion of holdings. Then with valuations in the trough, one can begin to selectively capitalize. All the variables are unknowable. It’s a simple exercise for the sake of illustrating the value of having cash available at the appropriate moment in time.
As previously stated, if you think leaving your hard-earned money in the hands of a professional will protect you, you are mistaken. Chuck Jaffe, MarketWatch columnist, penned a recent article which imparts this very notion. The piece’s opening headline states, “Only four funds have beaten the S&P 500 for the last eight years.” That’s four as in you can count the number of actively managed funds on one hand that can beat a simple index of the S&P 500 over the last eight years. Those four funds are all in healthcare, which means it has taken the tailwinds of what is arguably the strongest demographic opportunity for the next 10 to 15 years to beat a simple index.
The markets are cyclical and what was old is new and what is new is old. The sun may wane on indexing for a time and active stock picking may get revitalized. If you intend to be one of those stock pickers then it is imperative to have the cash available for opportune investment. I’ll share what I feel is a poignant quote from Charlie Bilello, of Pension Partners, that summarizes the value on boosting cash levels in one’s current portfolio. In the article, Bilello is referring to the ATAC rotation strategies that Pension Partners advise on and utilize, however the sentiment is equally applicable to what has been articulated in this post. To wit(emphasis mine),
Similar to the mid to late 1990’s the last few years have featured runaway gains in U.S. equities. Any strategy that was built to minimize downside over this time has dramatically underperformed as there has simply been no downside to capture. While some would view this as flaw in these strategies it is the only way they can work over time. In order to minimize downside you have to be willing to give up upside in return, and by extension this means underperforming during runaway phases in bull markets. There is no other way if your primary goal is to protect capital. The tide always turns and while out of favor today, preserving capital and managing risk will be back in vogue once more, but only after the declines occur.
Brush up on your valuation skills. The sacrifice of modest current returns versus potential outsized losses while waiting for the inevitable fire sale makes cash a superior asset. Set aside the ingrained notion of maintaining a current unproductive asset bearing debasement losses for the simple notion of sometime in the near future you could be buying the most productive businesses or assets on the planet for 40 to 60 cents on the dollar. Will we get another crack at the beginning of a true secular bull market beginning with a CAPE in the single digits? Possibly, but I’ll take a CAPE in the teens just as well and I’ll want to have the ammo available when such fortuitous circumstances(for some) arise.
I readily and regularly admit to not exactly being an intellectual heavyweight, so here’s an interview with Nassim Taleb from the Swiss website Finanz und Wirtschaft. They consistently feature quality international pieces from international guests. In the article, Taleb(a legitimate intellectual heavyweight) shares many of the same sentiments expressed in this post; just to add a touch of support to the claims.