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3 Things: Value of Cash, Valuations, Red Flags

  • Written by Syndicated Publisher No Comments Comments
    April 10, 2015

    Earlier this week I discussed the recent interview with Mohamed El-Erian and his valuation call and holding of cash in his portfolio.

    Not surprisingly, that topic recent a good bit of push back due to the current “zero” rate of return and the impact of inflation over time. I understand that argument and do not disagree. However, as I stated, there is a huge difference between the loss of future purchasing power and the destruction of investment capital.

    I have written previously that historically it is relatively unimportant that the markets are making new highs. The reality is that new highs represent about 5% of the markets action while the other 95% of the advance was making up previous losses. “Getting back to even” is not a long-term investing strategy.

    SP500-RecordHighs-022315

    In regards to El-Erian, his comments were a valuation call on the financial markets suggesting that currently having capital invested was likely to yield substantially lower or negative return in the future. This is an extremely important concept in understanding the “real value of cash.”

    The chart below shows the inflation adjusted return of $100 invested in the S&P 500 (using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller’s CAPE ratio. However, I have capped the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets in the past. Lastly, I calculated a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves to cash at a ratio of 23x.

    Stocks-Bonds-Cash-ValueOfCash-040915

    While no individual could effectively manage money this way, the importance of “cash” as an asset class is revealed. While the cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at low valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover.

    While we can debate over methodologies, allocations, etc., the point here is that “time frames” are crucial in the discussion of cash as an asset class. If an individual is “literally” burying cash in their backyard, then the discussion of loss of purchasing power is appropriate. However, if the holding of cash is a “tactical” holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future.

    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.  

    Markets Might Be Over Valued

    Continuing a bit further with El-Erian’s valuation call, my new friends at 720 Global just released a very interesting research report on market valuations.

    I have discussed a variety of valuations in the past from market capitalization to GDP, CAPE ratios and Tobin’s Q in relation to their current levels as compared to previous secular bull market peaks. (See here for latest update)

    However, in the report authored by Michael Lebowitz, he takes a different angle showing where the S&P 500 is currently priced versus where these valuation measures suggest it should be priced. To wit:

    “Corporate earnings and thus stock prices are driven by the economy. Despite the state of the economy and economic concerns we harbor, investors are investing hand over fist in assets whose valuations are predicated on strong economic growth in the future. As a result, most major U.S. stock indices are currently at or near all-time highs.

    A sizeable percentage of the gains are a result of an expansion in the price/earnings multiple. In other words, investors are willing to pay more today, than they did yesterday, for the same amount of historic earnings and or forecasted earnings. The graph below shows five popular gauges of valuation, including those used by the Federal Reserve and investing icon Warren Buffett. The colored circles show where the S&P 500 would be if investors valued earnings today as they did historically. Based on these five measures the S&P 500 is adding a 20% to 50% premium over what decades of history suggest is fair. These readings range from the 80th percentile to the 100th percentile in each case. Not unlike the rhetoric of the late 1990’s or mid-2000’s, there is no shortage of rationalizations for why such extraordinary valuations are reasonable and justifiable. The fact remains firmly in place, stocks are expensive.”

    StockValuations-Prices-040915

    “The all-important link between stock prices, economic and productivity growth, and true corporate earnings potential are being ignored. Stock prices and many other investment asset prices are indirectly supported by the actions and opinions of the central banks. Investors have become dangerously comfortable with this dubious arrangement despite the enormous market disequilibrium it is causing. History reminds us time and again that a state of disequilibrium is highly unstable and will ultimately revert to equilibrium – often violently so.”

    Warning Flags

    Jeff Saut, Raymond James’ Investment Strategist, has been a raging stock market bull for quite some time. He is also firmly of the belief that the U.S. markets have re-entered into a secular bull market that still has years left to run. However, despite his ongoing bullishness, he did pen some very interesting points on some “red flags” that currently exist in the market. To wit:

    “… as I stared at a chart of the D-J Transportation Average last week, which looks like it is making what a technical analyst would term a giant broadening top. The chart pattern begins in November with a false upside breakout (to ~9310) that is followed by a decline into mid-December (to ~8581). Those high and low points set the stage for the parallel channel the Trannies have been locked in for going on six months. Interestingly, the chart formation also shows a spread quadruple bottom (four low points). Therefore, if 8580 is decisively broken to the downside, it is going to look pretty ugly in the charts. While it would not be a Dow Theory ‘sell signal,’ it certainly would raise a red flag, at least on a short-term basis.

    Another ‘uncle point,’ I wrote about last Thursday is the 2060 level for the S&P 500. Hereto, a close below that level would not look good to me. Meanwhile, the MACD indicator is currently flashing the same type of warning signals it did in 1Q00 and 4Q07, not that I expect similar downside results.

    Then there is what Jason Goepfert, of SentimenTrader fame, wrote about last week. To wit,

    “Buying power available to investors is near an all-time low. The NYSE Available Cash figure has dropped to one of its lowest levels, and the last two times it was near this level, stocks struggled in the months ahead. According to the American Association of Individual Investors, mom-and-pop investors have their highest exposure to stocks since 2007, and nearly their lowest cushion of cash since 2000.”

    Cash-Asset-Ratio-SentimentTrader-040915

    Mr. Saut goes on to ignore these warning signs as he continues with his new secular bull market thesis.

    What’s the worse that could happen?

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.
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