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Recently, Seeking Alpha contributor Chuck Carnevale submitted an article that advised against holding assets allocated for investment in the form of cash. Like pretty much everything else Chuck writes, it's well worth reading. I won't re-cap it here, but I will try to make a case for the other side, since I am currently holding a fair amount of cash. I will argue the market is probably overvalued, that market valuation matters even to those who buy or hold individual stocks, and conclude by discussing some different approaches.

Is the stock market overvalued?

One of the most accepted and commonly used valuation metrics is the cyclically adjusted price/earnings ratio or CAPE. Introduced by Yale's Robert Shiller, CAPE compares current stock prices to average real earnings from the past ten years. Shiller's most recent data puts the CAPE at about 25, which is about the 85th percentile of historical CAPEs going back to 1945, and well above the post-WWII average of 18.

Some misleading headlines notwithstanding, Wharton professor Jeremy Siegel has acknowledged the CAPE's predictive power for future stock returns. However, he's also argued (persuasively to me) that the current CAPE is misleading because accounting rules have changed in a way that distorts the comparison between today's earnings and past earnings. But if you look at Siegel's slides (slide 20), using corporate profits from the National Income and Product Accounts for the earnings in the CAPE equation still suggested that the market was around 8-9% overvalued. This was back in September 2013, when the S&P 500 was around 1700. Back in August, noted investment manager and author Mebane Faber also wrote that US markets are expensive according to the CAPE even if prior earnings are adjusted to exclude the massive asset write-downs that happened during the financial crisis.

Tying a stock's market to the market of stocks

Why might potential buyers of individual stocks care about the stock market, or its valuation? Let's consider AFLAC (NYSE:AFL), a provider of life and supplemental health insurance. Below are the daily returns of AFL for the past ten years, plotted against the daily returns of the S&P 500 for the same period. We can see a pretty powerful tendency for the price of AFLAC's stock to go up when the stock market goes up, and for the price of AFLAC to go down when the stock market goes down. The statistics, shown beneath the graph, back up the visuals.

(click to enlarge)

The past relationship between AFLAC's stock price and the overall stock market is very hard to deny. In CAPM terms, the slope of the line - about 1.5 - would be labeled AFLAC's beta (assuming a risk-free rate of zero). Regardless of how one feels about the CAPM, beta is a quick and dirty way to measure the strength of the connection between the market for an individual stock, and the entire 'market of stocks'.

In practice a stock's beta will vary depending on the time-frame used to calculate it, and the assumed risk-free rate of return. Beta is a calculated statistic and not an intrinsic feature of a stock - it can and does change over time or with market sentiment. While many stocks have a lower beta than AFLAC, most stocks have a beta that is greater than zero, and I believe it is reasonable to expect that to continue to be the case moving forward.

The takeaway here is that if the market goes down, AFLAC's stock price - along with most other stock prices - is likely to go down with it, and if the market goes up, AFLAC's stock price is likely to go up with it. There is a connection between a stock and the stock market. And this makes sense, since the stock market consists of nothing more than the individual stocks that comprise it.

So, what to do?

If we believe that the market is overvalued, that price eventually follows value, and that the prices of the stocks that constitute the market generally move in concert with it, then a downward movement in the price of most stocks seems possible. 'Possible' is a very vague term, deliberately chosen. I agree with Chuck that attempting to predict short-term price movements is unwise for most of us, myself included. But predicting a downward price movement and preparing for a downward price movement are two very different things.

The simplest preparation is psychological. Holding your assets through ups and downs is not a bad approach, provided you have the resolve to continue to hold them through the downs. But I prefer a more active form of preparation - when the market's valuation seems conducive to a price decline, as is now the case, I prefer to hold some cash.

Every investment choice involves risk, and holding cash is no different. If the prices of the assets I own go up, I will see smaller gains than I would have if I have been fully invested in those assets. And regardless of price change, I may also forgo some of the dividends I would have received from being fully invested. However, if the prices of the assets I own go down, I benefit from holding cash in two ways. First, I see smaller losses than I otherwise would have. Second, and of greater importance to me, I will have cash on hand to be able to take advantage of the lower prices.

This second benefit is of particular importance to income investors. One reason to buy stock is to collect dividends, which will hopefully grow over time. Going back to AFLAC, the current dividend is $1.48 annually, yielding 2.24% if the price is $66. Should the price drop to $40 (where it was, not that long ago), that same dividend yields 3.7%. Assuming AFLAC's most recent dividend growth rate of 5.7%, it would take nine years for today's dividend to reach a 3.7% yield on cost. I'm not holding cash in fear of a market correction; I'm holding cash in hopes of one.

One common question/objection to this approach is: "But how will you know when to buy? Won't you always be tempted to see if it goes even lower?" This is a valid concern, and it's important to have a re-entry strategy. As a simple example, I might set my maximum equity allocation to 80%, and maintain that level whenever the CAPE is at or below 18. When the CAPE goes above 18 I would reduce my equity allocation by 2 * (CAPE - 18). So at a current CAPE of 25 my target equity allocation would be 80 - 2 * (25 - 18) = 66%. If my actual equity allocation was sufficiently less than 66%, I would buy. If my actual equity allocation was sufficiently more than 66%, I would trim positions that have gotten too large, or exit my least desirable positions, or just wait and accumulate cash until I reach the target. As the CAPE moved - whether from price changes or earnings changes - I would update my target equity allocation. This is just an example; each investor can and should develop an approach that works for them. Those who don't like the CAPE can use a different approach. There are also places to put assets other than stocks and cash; some might choose to hedge using options. The important thing - to me - is to have a plan and stick to it.

Find A Style That Works For You

When people that don't know much about investing learn that I follow stocks and the market closely, they sometimes ask what I think they should be doing. And I usually stammer something incoherent, and change the subject. I wondered why that was, but I have settled on an analogy that helps me understand. Investing is a lot like fashion (I'm horribly dressed, by the way). There are approaches that are definitely wrong - but there's no one approach that is the right approach. Every investor develops a style that suits his or her personality, goals and preferences. We draw inspiration from icons like Buffett or Lynch, and pick up ideas from other investors. Our approach often evolves as we gain experience. Some people, like Jim Simons or George Soros, can pull things off that would be catastrophic if an amateur like me tried them. So if people ask, I can share what's worked for me; but I can't tell anyone else what they should be doing, any more than I can tell them what clothes they should be wearing. (It's not a perfect analogy, but it's the best one I have so far. If you have a better or competing one I'd love to hear it in the comments). Chuck made a great case for a 'style' that refrains from holding cash in his article; hopefully I have laid out a coherent opposing case for a 'style' that does include holding cash in potentially overvalued markets here.

Source: A Case For Holding Some Cash In This Market