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As usual, I read with interest an article by Chuck Carnevale, this time one that opined that it is a mistake to be holding cash in today's market. I was immediately struck wondering whether he meant any cash, some cash, or all cash. It was a point that he didn't really make clear during his article. I mention this because there's obviously a world of difference in a portfolio allocated to 10% cash, versus one that is sitting on 90% cash, or one that is plotted somewhere in between.

On the whole, I think Chuck provides a wealth of investing knowledge through his writings, offering sensible, optimistic rationale for investing in stocks at low valuations. My writing today is not meant to necessarily rebuff his strategy or any strategy that focuses on full equity investment. However, I think even long-term investors with a more passive buy and hold inclination might benefit by expanding their investing repertoire from reliance on a pure quantitative tilt predicated on the assumption that equity prices always move higher.

Why Holding At Least Some Cash Makes Sense

Indeed, one of the major assumptions that Chuck or any long-term investing proponent makes is that equity prices will maintain their upward momentum in perpetuity. The following chart provides us with some historical performance perspective on the market, as measured via the DJIA, the Nasdaq, and the S&P 500. Take note of the red annotated areas of each chart, with each marking a span of time where a market top occurred and was followed by a prolonged period of pricing stagnation.

DJIA


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Nasdaq


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S&P 500


(Click to enlarge)

Pertaining to the Dow, it took 25 years for the index to fully recover from the rampant speculation leading to the crash of '29. The market took another 17 years to break out after it topped out again in 1966. The latest period of stagnation for both the Dow and S&P 500, a period now commonly referred to as "the lost decade," spanned from the apex of the technology and growth stock "bubble" in 2000, with the market not breaking out until earlier this year. The Nasdaq, as we well know, still sits beneath its highs assumed back in 2000. So while equity markets as a whole have maintained an upward trajectory through their existence, there have been extended dark periods from time to time. Further, we cannot be assured that the upward trajectory will persist.

I know I will take some cat calls for inviting a comparison to the Japanese market, but nonetheless here's a chart showing the history of the Nikkei 225. Certainly, an example of what goes up does not necessarily have to keep going up.


(Click to enlarge)

Getting back to the domestic market, while I'm not particularly fond of technical analysis, one who practices TA might certainly argue that the broader market as measured by the S&P, is now "breaking out" and should be bought. Whether one buys into that kind of thinking or not is arguable, I know I don't. On the opposite side of the analytical spectrum, fundamentalists that focus on operating valuations and macroeconomics have been urging caution for some time. Many, such as SA writer James Kostohryz have suggested that a bubble may currently be in the process of forming.

Thus, at a time when it appears we may be exiting a period of market stagnation, but also at a juncture when we are seeing valuations driven higher without accompanying robust growth, there may be good reason to take a little off the table. While I suspect Chuck might consider this as speculative, I prefer to consider it as a bit of tactical near-term portfolio management. I'm not going to exit the market, but my very near-term view of equities has grown suspect. Therefore, I consider it prudent to take action and protect capital when stocks that I own rise at a very disproportionate level compared to their earnings growth.

Protecting capital could take several forms. While most investors consider their positions as all or nothing propositions, I consider it most prudent to view a position, even one you may consider a "forever" one, as something that one can trade around. Thus, if you think as I do, that stocks like Procter & Gamble (NYSE:PG), Colgate (NYSE:CL) or Boeing (NYSE:BA), along with a slew of other names, have gotten expensive over the near-term, you might consider hedging your bets. Instead of selling out of them, you might consider just paring them down a bit. You could also take other action on a position you consider at risk, with option strategies like call writing and protective put purchases coming to mind.

Realizing the fact that stocks never move in a linear fashion up or down, whether in the midst of a secular bull or bear market, there should be an expectation for ongoing pricing peaks and valleys. While no investor will perfectly time a top or a bottom on a consistent basis, an ongoing system of paring and accumulating, while continuing to stay invested to a variable extent, would seem to be an alpha seeking portfolio strategy worth considering.

Another Reason Cash May Not Be A Bad Idea

With the Fed having created an unprecedented macroeconomic environment through its stimulative efforts, I consider it somewhat naive to think that financial markets will be unfettered as we proceed back to normal central bank policy. While optimists and the market may currently be telling us that a QE exit will be a non-event for most C Corporations, this is a conclusion no one can make with any degree of certitude. I would remind investors that the consequences of the mortgage debacle as it began to unwind in 2008 were not well understood either, with many blindsided by its disastrous effects.

While I'm not suggesting a market meltdown like we saw in winter '08/spring '09, I do consider the economic uncertainty and abnormal Fed policy of today a very rational reason to shy a bit on equity markets. If we all agree that the best time to be investing in stocks is when there is blood in the streets, today certainly is not the best time to invest. Five years post such a bloody scenario, much of the mess seems to have been cleaned up, thus buying stocks at these levels may not provide anywhere near the reward proposition it did in 2009.

Conclusion

How much cash anyone holds in a portfolio, similar to any other kind of investment, should be predicated on careful risk/reward evaluation. Market history tells us there have been several decades where holding cash or bonds would have been a much more profitable endeavor than holding stocks. Market history also tells us that stocks over the long run go up. The biggest downside to cash today is the lack of nominal return one can expect compared to previous decades.

Many market prognosticators preach that time in the market is better than timing the market. For those predisposed to making poor decisions, in effect buying high and selling low, instead of the opposite, then perhaps a fully invested, no cash allocation is an appropriate solution.

I would suggest that a combination of time in the market alongside some level of tactical timing with a variable, perpetual cash allocation, offers an alternate solution for other investors keen on improving upon index-like buy and hold returns. In so doing, one exposes themselves to a market that may be destined to go higher, yet affords themselves the opportunity to optimize return by trimming or accumulating overall equity allocation, continually, thoughtfully, and with ready cash, compensating for the changing times in which we invest.

Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

Source: Why Holding Cash May Not Be A Bad Idea In Today's Market