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Technically Speaking: The Real Value Of Cash

  • Written by Syndicated Publisher No Comments Comments
    November 25, 2015

    With the “inmates running the asylum” during a holiday-shortened trading week, the upward bias to the market is set to continue. However, as I addressed last week:

    As we progress through the last two months of the year, historical tendencies suggest a bias to the upside. This is particularly the case given the weakness this past summer which has left many mutual and hedge funds trailing their benchmarks. The need to play ‘catch-up’ will likely create a push into larger capitalization stocks as portfolios are ‘window dressed’ for year end reporting.

    This traditional ‘Santa Claus’ rally, however, does not guarantee the resumption of the ongoing ‘bull market’ into 2016. The chart below lays out my expectation for the market through the end of the year.”

    SP500-MarketUpdate-112315-2

    “With the markets currently oversold on a very short-term basis, the current probability is a rally into the ‘Thanksgiving’ holiday next week and potentially into the first week of December. As opposed to my rudimentary projections, the push higher will likely be a ‘choppy’ advance rather than a straight line.”

    So far, the analysis over the last several weeks has continued to play out as expected. However, and this is crucially important, a near-term expectation of a bullish advance due to the recent correction and seasonal tendencies is not the same as long-term bullish outlook. 

    As stated above, while seasonality likely holds the cards through the end of this year, projecting much beyond that window is foolishness. 

    The Real Value Of Cash

    This brings to mind a call I had on the radio show recently discussing his advisor’s reluctance to hold cash. 

    The argument against holding cash goes this way:

    “If you hold cash you lose value over time to inflation.”

    This is a true statement if you hold cash for an EXTREMELY long period. However, holding cash as a “hedge” against market volatility during periods of elevated uncertainty is a different matter entirely. 

    As I discussed previously:

    “I have written previously that historically it is relatively unimportant 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 a market environment that is extremely overvalued, the projection of long-term forward returns is exceedingly low. This, of course, does not mean that markets just trade sideways, but in rather large swings between exhilarating rises and spirit-crushing declines. This is an extremely important concept in understanding the “real value of cash.”

    Valuation-ForwardReturn-20yrs-070215

    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 back to cash at a ratio of 23x.

    I have adjusted the value of holding cash for the annual inflation rate which is why during the sharp rise in inflation in the 1970’s there is a downward slope in the value of cash. However, while the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset with respect to reinvestment may be different since asset prices are negatively impacted by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises.

    Stocks-Bonds-Cash-ValueOfCash-040915-2

    While no individual could effectively manage money this way, the importance of “cash” as an asset class is revealed. While cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at lower 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 the loss of purchasing power is appropriate.

    However, if 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.

    Much of the mainstream media will quickly disagree with the concept of holding cash and tout long-term returns as the reason to just remain invested in both good times and bad. The problem is that it is YOUR money at risk. Furthermore, most individuals lack the “time” necessary to truly capture 30 to 60-year return averages.

    For individuals, trying to save for their retirement, there are several important considerations with respect to cash as an asset class:

    1. Cash is an effective hedge against market loss.
    2. Cash provides an opportunity to take advantage of market declines.
    3. Cash provides stability during times of uncertainty (reduces emotional mistakes)

    Importantly, 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 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. 

    As John Hussman recently noted:

    The overall economic and financial landscape, then, is one where obscene valuations imply zero or negative S&P 500 total returns for more than a decade — an outcome that is largely baked-in-the-cake regardless of shorter term economic or speculative factors. Presently, market internals remain unfavorable as well. Coming off of recent overvalued, overbought, overbullish extremes, this has historically opened a clear vulnerability of the market to air-pockets, free-falls and crashes.”

    As stated above, near zero returns do not imply that each year will have a zero rate of return. However, as a quick review of the past 15 years shows, markets can trade in very wide ranges leaving those who “rode it out” little to show for their emotional wear.

    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.

    Just something to think about.

    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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