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Market Tops and 5 Good Reasons for Cash on the Sidelines

Market Tops and 5 Good Reasons for Cash on the Sidelines

Updated on June 22nd, 2020

Reducing Risk or Market Timing?

Wall Street and the mainstream financial publications have brainwashed the public to be fully invested at all times. You can’t time the market, they say. All the academic books on the subject say the same thing. They publish meaningless statistics that say trite things like “If you were out of the market the best 10 days over the last 30 years, you’d have a negative return today!” Okay, so how about if you missed 10 of the best days and 10 of the worst days, what would your gain be then? It’s very convenient to assume that you’d miss only the best days.

There are plenty of times when you shouldn’t be fully invested in the stock market and should be raising more cash (or bonds) in your portfolio:

1) You are within 5 years of retirement.
2) You don’t have several months of emergency cash.
3) You have a large purchase coming up.
4) The stock market has gained significantly over the prior year and you need to re-balance your risk allocation.
5) You have been paying attention to the signs of an impending draw down (below).

Ulterior motives aside, the arguments against taking risk off the table are exaggerated Straw-man attacks, suggesting that the only way to do it is to switch from 100% stocks to 100% cash on a regular basis. It’s framed as if to be successful at it, you must pick the exact top and the exact bottom, which is clearly impossible. I’m not advocating an all or nothing approach and I’m certainly not suggesting money is moved back and forth frequently.

But when the market has soared as much as it had up until the end of 2019, your allocation to stocks would have been a lot more than your allocation to bonds and cash, and therefore, raising cash was a prudent function of proper asset allocation.

What’s worse, longing for paper wealth you thought you had, or having peace of mind that a portion of your assets had zero volatility but didn’t earn you much? I’d say losing wealth hurts a lot more than not gaining as much as you could have. And the math has the potential to work on your side when you take risk off. If you move a portion of your portfolio to cash and the market ascends 30% over the next year, but then drops 30% the following year, that cash is actually ahead of the game by 9% (130%*70%=91%).

In fact, if you had chosen to sit out the market anytime in the last three years from today, you’d be ahead of the game because the recent rout has wiped out 3 years. The key lesson is that when the market corrects, it usually takes out several months to years of market gains and market corrections occur quite frequently about every other year or so.

Total Market Return For Last Three Years Is Zero

But it is important not to capitulate to the Fear-Of-Missing-Out (FOMO) where you put the money back in after taking it out because the market continues to churn higher. The goal is to re-balance your risk and asset allocation and keep it that way until it is necessary to re-balance again.

To protect against market downside, what are some other options?

1) Buy puts
2) Short stocks (hedging)

But neither of these options is free and they expose you to other risks like losing your option premium or the shorted stocks continue to ascend higher. The cheapest thing to protect against downside is to just sell some of your equity and raise cash.

When is a good time to raise cash?

In “A Random Walk Down Wall Street,” Malkiel points out that news by its very nature is random, so therefore the market movements in reaction to the news will be random. While I can agree with that statement, there are times when the market is setup to react more negatively to bad news than other times. These are the times when you want to have extra cash waiting on the sidelines ready to swoop in and pick up some severely discounted assets.

While some corrections appear to come out of left field, other ones are pretty obvious. The draw-down going into 2020 was the easiest call in history. Every measure of valuation had showed that it was extremely overvalued and the S&P500 had risen 14% in less than 5 months. I recall reading opinions in Barron’s where the ‘experts’ were doing mental gymnastics to justify the valuations. “Well, you see, with the ten year bond yield so low, equities are not so overvalued when you subtract the equity yield from it…”

All the market needed was a pin prick. If it wasn’t the pandemic, it would have been the oil price war between Russia and Saudi Arabia. If it wasn’t either of those, it would have been something else. People needed a reason to sell, and either of those reasons gave them one.

What were some of the biggest tells that 2018 and 2020 were bound to have a steep correction?

  1. Ridiculous headlines from ‘experts’ telling you to buy. Hedge funds talk their books and it’s almost criminal. They will tell you what to do and take the opposite side of the trade.
Before he retired I don’t think this guy ever had a single correct call
If you are holding cash, you’re going to feel pretty stupid!
Cash is Trash!
There is no risk!

They do it on the downside too:

Hell is coming! Sell so my short hedges gain value!

When you see headlines like this, exercise extreme caution.

2. Magazine covers start telling everyone how great or bad the situation on Wall Street is. This has the effect of bringing in new buyers or sellers for anyone who wasn’t previously paying attention.

3. Price-to-Sales, Price-to-Earnings, Forward P/E, CAPE P/E, Put/Call Ratio, Fear and Greed Index, AAII investors survey, Cash sitting in Berkshire Hathaway, etc. were all at extremes.

4. 2018 had an extra tell where the trend line suddenly accelerated upwards, indicating panic buying.

Panic buying right at the beginning of 2018

Why Bother?

You may be comfortable with the buy-and-hold approach and feel you don’t have to pay attention because “it will eventually come back.” While historically that is true, it certainly feels better to lose less than the market did. More importantly, some of the great bumps in wealth can come from the troughs of bear markets by taking advantage of some amazing deals from sellers willing to get out at any price.

The draw down in 2020 is a perfect example of what I am referring to because even though the index has only dropped about 30%, the median stock has dropped 50%. Quality companies. Companies that will survive and eventually return to their old highs and beyond once the pandemic is long gone.

Value Line Geometric Composite Long Term
Value Line Geometric Composite Recent

What’s with the difference between the median stock and the S&P500? Mega cap stocks haven’t dropped as much and have been keeping the indexes afloat.

Why has the median stock dropped so much?

It’s because of forced liquidation. Lots of people in the market use leverage and short options to increase their returns. Of course this also increases their risk. When the market falls and the value of their accounts fall, so does their margin. Rapidly. They will either have to wire money into their accounts to maintain their positions or the broker will forcefully liquidate holdings. This indiscriminate selling causes retail traders to get out at any price… at the worst possible time.

Less liquid stocks like Preferred Stocks are prime targets for acquisition during times like these.

Final Thoughts

While buying-and-holding before and throughout the ordeal will get you back to even, buying in the trough can get you that extra 50-100% on those new purchases. You won’t get the exact bottom, but you don’t have to. You just have to make sure that you don’t deploy all your cash at the same time. Buy a little bit here and there for quality companies at discount.

If you had 10% of your portfolio in cash that you deploy in the trough and those assets return 30% over the next year (frankly, I have seen some of the stocks I follow return 50-200% in a day after the panic selling ended over this last week), that is an extra 3% gain on your portfolio for the year. Over time, small percentage gains can amount to large sums of money through the power of compounding.

The time to raise cash is when the market is hitting record highs and the time to deploy cash is when it is hitting yearly lows, not the opposite which is what the average investor does.

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Ryan

After graduating with $75,000 in student loan debt, Ryan began a professional career in finance, aggressively saved and invested and became a self-made millennial millionaire in early 2019. He holds a Master's degree in Computational Finance, a Master's degree in Economics, and a Bachelor's degree in Mathematics. His two passions are investing and traveling.

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