People are way to quick to assume that cash is an enormous mistake of a position in a portfolio. I am about to have a fun time debunking this one as it is complete and utter conventional wisdom nonsense. It may have been a tad more difficult to make this argument a couple years ago, but now many money market funds are returning over 2%, and the old saying Cash is King is being remembered.
The time for cash to be a prominent portfolio position is specific. Cash is not always King, but when valuations are at extremes, it is a wise position. The term “extremes” is subjective, but I will let you be the judge. Below you will find a chart of the Shiller PE ratio. The Shiller PE ratio is a special kind of PE ratio. First, a PE ratio is a price to earnings ratio. It is a valuation metric, and it tells you the multiple that each share of stock costs in relation to earnings. The significance is that if a company makes $1/share and you pay $50 for the share, then the company is priced at 50x earnings. Earnings can be volatile so PEs can be subject to short term volatility that should not affect the valuation of the company, but due to the way the PE ratio is calculated it may unfairly signal that a company is overvalued or undervalued. The beauty of the Shiller PE ratio is that instead of just using recent earnings, it uses the average earnings of the past 10 years in the denominator. This smooths out the ratio from any arguably insignificant volatility. The current Shiller PE ratio resides at levels only seen around the time of the 1929 stock market crash, which preceded the Great Depression, and the dot-com bust of 2000. Also, note that before the prior selloff the Shiller PE ratio for this cycle was higher than that of the 1929 cycle peak making it by historic Shiller PE ratio standards the second most overvalued stock market in US history.
The focus of this post is not how such irrational company valuations occur, but what they signify. Ever hear of buy low sell high? Well simplistically, this could serve as a guide for a novice investor. As one can see when stocks are overvalued, they are due for correction. Let me provide you with some downside risk reference. Peak to trough, the crash of 1929 cost investors in the Dow Jones Industrial Average 89%. Peak to trough, the dot-com bust of 2000 cost investors in the Dow Jones Industrial Average 34%, but more relevant is what was lost in the Nasdaq 100. The Nasdaq 100 is a composite of the 100 largest tech companies in the US, and this index lost 81%.
I am not saying that because valuations are on par with these past disasters that north of 80% losses are in the cards. What I am saying though is that the market is just like a casino, and if you do not step away from the table when you still have chips, then those past “gains” may be nothing but a memory.
Let us now consider the naysayers. They will say things along the lines of look at all the gains that you are missing out on as overvaluation extends into even more ridiculous territory. They may ask you, “When will you get back in the market?” I would propose the question, “When will you get out?”
I do not anticipate a continuation of this trend, but it is certainly noteworthy that cash was even the best performing asset in 2018 per the above figure.
So in holding an allocation towards cash, not only will you be relatively defended versus adverse market conditions, but you will even be compensated for it. Let us not forget the last benefit. When stock markets crash, investor sentiment tends to sway to a state of over panic, which creates fire sales.
Warren Buffett famously said, “Be fearful when others are greedy and greedy when others are fearful.”
You cannot take advantage of the fire sales and the fear unless you have dry gun powder (cash) at the ready. It should come as no surprise in such cyclical times that the legend is preparing.
At the beginning of 2018, Buffett and Berkshire Hathaway sat on $116 billion in reserve. This cash is crisis ready. In line with what the Shiller PE ratio was telling us, Buffet has yet to see value opportunities arise. The difficulty with cash is that people will constantly tell you that you are a fool for holding it. I presume that Buffett made a few mistakes during the year due to shareholder pressure, but nevertheless he still has over $100 billion in reserves, and is ready for what may be coming based on history.