High Cash Levels and Your Portfolio

by Alexander Green

If you’re like many investors, a subconscious bias is currently wreaking havoc on your investment portfolio. Recognize this and a whole new world of opportunities will open up to you. Here’s why…

Psychological studies confirm that we all have biases. Yet we’re generally unaware of them. When it comes to investing, few of them do more harm than “recency bias.” This is the tendency of investors to extrapolate recent events into the future indefinitely.

The Recency Bias Creates a “New Era” of Growth

When technology and Internet stocks were hot in the late 90s, for example, investors began talking of a “New Era” of limitless technological growth. The truth, of course, is that technological innovation does steadily increase. Alas, the same cannot be said of technology stocks.

Years of sharply rising prices lulled investors into a false sense of complacency. Investors didn’t just plan to hold Lucent (NYSE: ALU) and JDS Uniphase (Nasdaq: JDSU) long term. Many began calling them “legacy stocks,” companies that were so exceptional that they would pass them on to their children and grandchildren.

Yet someone less obsessed with recent performance and more familiar with the lessons of history might have recollected that behind every bull market is a growling bear market. From the peak in March 2000 to the bottom in October 2002, the Nasdaq (.IXIC) lost more than three quarters of its value.

Most of your children and grandchildren would have been better off with a passbook savings account or the use of a trailing stop. Of course, recency bias works the other way, too. Last year the S&P 500 (.INX) dived 38%, its worst performance since 1931.

Now the galloping herd is convinced that stocks have nowhere to go but down. Mutual fund flow figures show investors yanked tens of billions of dollars out of equity funds in the fourth quarter alone. Much of that money is piling into bank accounts and money market funds. Yes, they’re super safe, but they pay a national average of less than 1%.

The Recency Bias: Teaching Investors That Nothing Is Better Than Something

Still, recency bias convinces them that earning next to nothing is better than losing something. Once again, they’re rationalizing. Sure, stocks may continue down for a while, but look beyond this week’s headlines and you may see opportunity and not just risk.

Today there is more money available to buy shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds is equal to 74% of the market value of U.S. companies, the highest ratio since 1990 according to the Federal Reserve.

What has happened in the past when cash reached these levels?

• In September 1974, cash on hand reached $604.5 billion, representing a record 1.21 times U.S. stock market capitalization. That preceded a 31% gain in equities between October 1974 and March 1975.
• In July 1982, just as a 20-month bear market was ending, cash as a percentage of the U.S. stock market’s value rose to 95%. The S&P 500 began a six-month, 36% advance.

According to Bloomberg, the eight previous times that cash peaked compared with the market’s capitalization, the S&P 500 rose an average 24% in six months.

There are no guarantees, of course, but this is a very positive near-term signal for the market.

Smart investors - even bearish ones - understand the significance of high cash levels. For example, Leuthold Group, whose Grizzly Short Fund returned 83% in 2008 thanks to bets against equities, recently put out a bulletin calling stocks “one of the great buying opportunities of your lifetime.”

The report pointed out that the ratio of cash on hand to U.S. market capitalization jumped 86% in the first 11 months of last year. That’s the biggest increase since the Fed began keeping records in 1959.

When Will Investors Wake Up From This Recency Bias?

Some day soon, millions of investors will wake up to this recency bias and the fact that their cash is earning a negative return after taxes and inflation. And when they do, money will start migrating back to the market.

One good reason? In addition to capital gains potential, stocks currently yield three times as much as cash.

However, investors suffering from recency bias will not be persuaded by facts, figures, historical parallels or rational arguments. Unbeknown to many of them, emotions are dictating their actions, not reason.

If history is any guide, they won’t leave the safety of cash until a rising market - and a whole new round of recency bias - convinces them that it’s safe to own equities again.

And they wonder why they don’t buy low and sell high.

Comments

[ArtfulDodger:]

Mr. Green:

This is the first article I've ever seen on this site that I agree with every word of. (This, however, may not be good!)

I have been aware of this quirk among humans for quite a while, and it stands firm today not only among average investors, but also within the financial media.

They often bring up yesterday or today and extrapolate that into a permanent future.

This is probably fine for traders, but investors must look out to the future -- and I think we have to do that by understanding the past, although no two market eras are the same.

E.g., the government's recent intervention in the economy pales anything in the past. We can only estimate what amounts to about 15% of GNP tossed into the system will bring about.

Excellent article! Thank you very much.

Artful

Jan 13 08:33 AM

[prudentinve...:]

You state: ".....the eight previous times that cash peaked compared with the market’s capitalization, the S&P 500 rose an average 24% in six months". It would have been enlightening to specify these eight occasions, and to comment on the similarity (or lack thereof) between them and the current situation.

From my perspective, the market is just returning now to the vicinity of its long-term trends, simply recovering from the era of the Great Bubbles; as discussed in today's article by John Lounsbury

seekingalpha.com/artic...

For the first time since 2003, there have recently been, and are now, some good valuations in stocks, but I would not call the overall market valuation compelling or cheap. It would not surprise me at all if five years from now, the market is at levels very similar to today's. This would be a departure from what happened after big drops of the past twenty years, but history does not always repeat itself.

Jan 13 08:38 AM

[Larry House:]

Investors can turn to other assets than stocks to get better returns. You assume they are either in treasuries or go to stocks. That is not necessarily true. We are entering an era of less debt and more cash. The thawing that you talk about may be many, many years away. It is a real error, in my view, to think that at some point in the near future everything is going to jump back to what it was two years ago. Ain't going to happen.

Jan 13 10:00 AM

[axelrod608:]

>> "There are no guarantees, of course," >>

And therein lies the problem. For traders who spend most of their working hours focused on the markets, it may be wise to get that cash back in action. But for the casual, occasional investor - the one that likes to buy and hold ( ? buy and forget ? ) these are perilous times.

prudentinvestor makes a good point - is this time comparable to previous downturns ? I'm thinking it isn't.

I'm buying resource trusts that pay regular dividends. They've been hammered, and will probably go lower, but my "window" is at least 10 years. If by then the economy has not recovered I figure it wouldn't make much difference what I do with the money now.

Oh, and I do and will sell on pops. I believe the nimble trader will be rewarded in this and coming years. "Buy and hold" is a death wish in this market.

Jan 13 10:21 AM

[hrant:]

imagine investing $10,000 in 1998 in the s p 500 have less now $10,000 today . US saving bonds did
much better . now i am into PFF type of ETF on bonds . I predict the next scandal : the realization that mutual funds addind zero value to the small investor .

Jan 13 11:23 AM

[Smarty_Pants:]

While you are standing in the midst of a shoe dropping extravaganza it is most definitely not prudent to assume extra risk.

Just ask the former shareholders of Fannie Mae, Freddie Mac, LEH, AIG, WaMu, and probably soon enough Citi, each of whom bought at "incredibly" low prices only to discover that this time it really is 'different' and that stocks can and do go to zero.

As long as the politicians and bureaucrats are continuing to thrash about blindly trying to 'fix' things there will be greater risks involving possibly much greater losses.

While it may be true that there are opportunities today that haven't been seen in some time, it is also true that we haven't seen so many marquee stocks go bust in a few months since the 30s.

It took many years to resolve the difficulties back then and it's likely to take a good while to resolve them now as well. Any nibbling done now should entail a primary focus on minimizing the risk involved while providing a fair chance for either income or a rebounding price.

axelrod has the right idea. Safe returns are preferred over potentially spectacular gains that might turn into busts.

Investing will return to the standards used by your great grandparents. Income and stability.

Jan 13 12:05 PM

[Phil Trupp:]

Mr. Green's thesis is hardly new, and it relies on frayed logic (logic frayed by overuse) to push the hardly astonishing concept of buy low, sell high--a concept which applies to every form of merchandise, including equities. What Mr. Green seems to overlook is the paradigm shift taking place in today's marco economy. We have entered "bailout" country, a time in which the federal government is asserting itself as a primary economic driver in the style of modern Western European economies. Treasury and the Fed are currently in the process of creating a "Lender of Last Resort" mechanism which will change the way banks do business and, hopefully, moderate market volatility. Beefed up enforcement at SEC, which may merge with the CFTC, also portends a lowering of 2008-style shorting, a practice that has drained billions of dollars value from the markets. The future of inverse ETFs also is being debated. Hopefully these time bombs will be banned. Old-fashioned puts will come back into style to replace these inverse destroyers of wealth. In the end, I believe investors would be wise to be a little more patient and take a careful measure of the new Obamanomic order of battle before lurching back into the equity markets.

Jan 13 12:10 PM

[Smarty_Pants:]

"portends a lowering of 2008-style shorting, a practice that has drained billions of dollars value from the markets. ... Old-fashioned puts will come back into style" - Phil Trupp

Phil: Can't have one without the other. The moment after you buy a put, the market maker who sold them to you goes into the stock market and shorts an equivalent amount of stock to offset his risk. When he finds someone else to buy those puts from he unwinds his short position in the stock.

By doing this he makes sure that changes in the stock price won't cause his option position to lose money. When he offsets the option position on the other side of the spread (locking in his profit, ask - bid) he can offset the short position in the stock.

This is how the option market maker makes his money. Buying at the bid and selling at the ask on options. Between those two events he hedges in the stock itself, either going long or short as needed.

If you ban shorting in the stock, the difference in the bid and ask for the put options will greatly widen so the market maker can work with the greater risk involved in selling puts.

From an article found online:

CHICAGO, Oct 6 - The U.S. clampdown on short selling has made it difficult for option market makers to maintain orderly trading and raised the cost of protecting investments at a time when options are most needed to weather the maelstrom on Wall Street.

The ban on the short selling of more than 950 financial stocks ... has already hindered the growth in the U.S. options market because it raised transaction costs for customers, placed a burden on option market makers, and reduced volume.

Investors have found the cost of protection has shot up as bid/ask option spreads become wider in many financial stocks.

The result is that put options have become generally more expensive compared to call options.

news.alibaba.com/artic...

Jan 13 12:56 PM

[nmelendez:]

I have never heard of a stupider argument to be in equities. When the S&P went down 10% i went straight to cash. I have traded a couple times, bringing up my earnings.
It took from 1931 to 1950 , 20 years, for the dow to recover during the great depression. Maybe this won't be like it. Care to gamble your life's earnings on it?
In the meantime deflation has made my cash more valuable.

Jan 13 07:11 PM

[The Premium...:]

Historically when the bear is finished ravaging it's prey P/E's are in the single digits and the everyman wants nothing to do with stocks. We're not there yet. Don't you think this type of economic calamity warrants at least the historic norm?

Jan 13 09:31 PM

[adAstra:]

It might be time to buy, but I get the feeling that we're still a few months off.

One useful fact that wasn't mentioned was the average peak cash %. From the two examples given, we're not even at the mean yet so more cash will probably be pulled out.

Additionally, given the significant debt levels in the US, I would argue that we are more likely to overshoot the average peak cash than undershoot. People will need cash to pay off their debts, to pay their mortgages, etc.

Jan 13 11:47 PM