With almost all asset classes trading at very high valuations today, should you remain fully invested in stocks and bonds? Many would recommend to stay in the market and maintain a fixed allocation to different asset classes. While I agree that staying invested in the market is important, I would recommend you to consider increasing the weighting of one asset class that many forget: cash.
Cash seems to have become the most contrarian of all asset classes today. Everybody wants to be fully invested in the market to not miss the next potential bull movement. People are getting more and more greedy and you know the consequences: financial assets get bid up and trade today at above historic average valuations.
Bonds yield close to nothing and the expected returns of stocks are in the low-single digit area. So ask yourself: are you really missing that much by holding some cash today?
Asset allocation and weighting is a very relative question. Different asset classes must be compared and assessed against each other in order to determine what portfolio structure satisfy best the risk tolerance and objectives of the investor. Typical portfolios will be divided between stocks, bonds and possibly some alternative assets such as real estate. Since the expected return of cash is close to zero, it is often a quickly eliminated asset class when considering the weighting of the portfolio.
But how attractive are bonds and stocks in 2016? And more importantly, how risky are they at today's valuation compared to cash?
Bonds yield close to nothing and are exposed to significant interest rate risk
Bonds are today trading at some of the lowest yields ever and generally considered as being very overvalued.
In many cases, they do not provide any real return after inflation and taxes to their investors and provide no protection in case of severe unexpected inflation or increases in interest rates.
I think that bonds are very overvalued. If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I'd do it. But that's not my game, and it can't be done in the kind of quantity that would make sense for us. But I think that bonds are very overvalued. I'll put it that way.
Buffett made this statement not long ago; it was on May 4, 2015, on CNBC. Since then, rates have gone down further and even achieved the negative zone in Europe where you now have to pay to lend money. Buffett is not famous for taking short positions, but in this interview, he revealed that he would short this one asset class: bonds.
So relative to bonds, which make up the largest segment of the financial market, cash seem pretty attractive to me. You are not likely to have high opportunity cost by holding cash instead of investing in bonds. Perhaps, you could argue that rates can still go lower in the US, and that therefore you could increase your return in the form of capital appreciation. Note, however, that the lower the rates go, the bigger the bubble will become and the harder the landing will be once rates get back to historic normal levels. Cash at least is liquid, unlikely to suddenly lose its value, and can be stored until better yields present themselves.
Stocks have expected returns of about 4% per year and asymmetric risk on the downside
While bonds are extremely overvalued, you could argue that stocks present a better alternative at current valuations. I would agree on that one; however, I would remark that stocks are also very expensive relative to their historical average valuations. Their P/E multiple is today way beyond their average. The market is currently pricing the S&P 500 at over 25 times its earnings. The historical mean being only 15.6 times or 40% cheaper than today.
You will note that historically every single time the P/E ratio passed 25, it was later followed by a bear market. Every single time. Ray Dalio, founder and co-chief investment officer of the world's largest hedge fund, Bridgewater Associates, believes that the expected returns for stocks are about 4% at current high valuations and that volatility will be above average. This equals approximately the current earning yield of the S&P 500.
Get ready for lower than normal returns with greater than normal risk. Take current bond yield (less than 2%) and cash (0%) and compare that to something like a 4% expected return on equities. Because of volatility, the 4% expected annual return pick up of equities over cash, or 2% over bonds, can be lost in a day or two.
This does not sound too good to me either. The fundamentals of the global economy are not very strong, earnings are flattening, we risk a new recession and a potential new stock market crash, and the expected returns do not compensate for the risks undertaken at current high valuations.
Don't get me wrong; I am very long on stocks, but I am just trying to point out that the risk/reward ratio of stocks is not necessarily much better than that of cash today. While I agree that even a 4% expected return is better than nothing, you could also say that the risk of a sudden large loss isn't compensated by a large enough return. Stocks trade at very high multiples of earnings which equate to a low expected return and bonds yield close to nothing, so wouldn't it be reasonable to hold some cash aside?
Cash: the contrarian alternative…
Cash can be held without significant risk of losing value over the short run. We are today in a more deflationary environment, and it seems unlikely that we get high inflation anytime soon. By holding cash, you position yourself to take advantage of the next crisis, and will be able to allocate later at much lower valuations and achieve higher expected returns. You store the value for a future time and accept the low-single digit opportunity cost.
The investor that tends to outperform during a bear market is the one who had enough dry powder to buy assets when they were cheap. Our current bull market has been abnormally long and asset prices are today artificially valued at above average valuations which are not justified by business economics. I have no idea when the next bear market will be, but I feel quite certain that it will occur, and until then, the expected returns from financial assets are likely to be very low. The opportunity cost could well be worth the security provided by cash.
Stay invested in the market at all time, but not necessarily fully. When asset prices get very high and expected returns are low, there is nothing wrong with holding more cash. In today's market environment, cash has many positive attributes and is becoming more competitive with stocks and bonds. Cash should remain a smaller portion of your portfolio, but perhaps 10-20% in cash would be appropriate. It will not cost you a lot in form of opportunity cost, but will give you peace of mind and protection for the day when the bull market ends. Once the valuations get back to normal levels, I will feel comfortable being 100% invested with only the strict minimum in cash aside.
I, however, do not want to mislead you and cannot over-stress this enough: You have to keep most of your portfolio invested because you never know when the next bear market will be. It could take years for the valuations to start going down. Until then, even a low 4% expected return of bonds is more attractive than the 0% of cash. Cash should only be one asset as part of a diversified portfolio of other assets. This portfolio structure could be a win-win as if the market keeps going up, the investor is participating and if the market goes down, there is dry powder to buy cheaper.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.