Connect with us

Economy

Should you hoard cash like Warren Buffett and the private equity players?

Published

on

“I hate cash,” Warren Buffett said in an interview to CNBC, back in May of this year. However, by the end of second quarter, Berkshire Hathaway Inc., a company run by him for over five decades had $100 billion in cash and cash equivalents because Buffett is unable to find the right valuation to buy.

// -- Discuss and ask questions in our community on Workplace.

Key observations

  1. Warren Buffett is sitting on $100 billion of cash, waiting for the right opportunity to invest
  2. Private equity managers are holding about $963 billion in dry powder
  3. The S&P 500 is overvalued compared to historical numbers
  4. The US Fed’s tightening cycle and shrinking of balance sheet can lead to a recession
  5. How should investors approach the current markets

Similarly, private equity managers are sitting with record $963.3 billion in cash, according to researcher Preqin Ltd, reports Bloomberg. Are these warning signs of stocks being overvalued or is it a sign that there is enough money waiting on the sidelines to enter on every small dip, therefore, the investors should not expect a large correction in the near future.

// -- Become a yearly Platinum Member and save 69 USD and get access to our secret group on Workplace. Click here to change your current membership -- //

What should the investor do? Raise the cash percentage in his portfolio and earn a paltry 1-2% return on it or stay in the market and ride the rally with a higher risk of a pullback? Let’s see.

Valuations are rich

Availability of easy money, buoyed by the accommodative monetary policy of the various central banks across the developed nations has boosted stock prices to lofty levels.

Source: multpl.com

At the current levels, the S&P 500 is quoting at a PE ratio of 24.69, which is way above the mean ratio of 15.67. Does this mean that the markets will crash tomorrow?

No! However, it shows that the risk of a downside is high because traders are paying high valuations to own shares of their favorite companies. If for some reason, the companies are unable to meet expectations, a fall is likely.

Similarly, another popular metric to measure the valuation of the index is the Shiller PE ratio, developed by Robert J. Shiller, the Nobel Laureate, economist, academic, best-selling author, and Sterling Professor of Economics at Yale University.

Source: multpl.com

The Shiller PE ratio is quoting at 30.31, a level which has been exceeded only during the dotcom bubble and we all know what happened when the bubble burst.

However, the critics point out that even at the lows of 2009, the Shiller PE ratio was about 15, just below the mean of 16.78. If traders had waited for lower levels, they would have missed the greatest opportunity of their lifetimes because the S&P 500 has risen more than 270% in the past eight years. Therefore, their argument is that when a system did not signal a bottom correctly, why follow it when it’s signaling a top?

They have a point. However, we have to keep in mind that most of the rally following the last financial crisis was the result of the Federal Reserve’s quantitative easing (QE) programs and zero interest rate policy (ZIRP).

Source: Zerohedge

The chart clearly shows the spikes in the S&P 500, as and when the Fed announced a QE. With a huge amount of liquidity squashing around, it is no surprise that a large percentage of it was invested into the equity markets, which led to the massive rise. Therefore, it is not fair to blame the Shiller PE ratio entirely.

But why has the stock market not fallen off the cliff, since the Fed stopped its QE measures and started hiking rates?

The Fed first hiked rates in December 2015 and thereafter waited for another year before raising rates again. In between, they were quick to come to the market’s rescue on every correction.

The Fed has become increasingly hawkish and has accelerated its pace of rate hikes only after the Presidential elections in November 2016. In 2017, it has already hiked rates twice and is likely to hike once again before the end of the year.

Furthermore, it is also likely to start shrinking its massive balance sheet soon. History shows that five out of the past six times the Fed has done that, the economy has faced a recession. Similarly, 10 out of 13 previous tightening cycles have led to a recession.

Wow. That’s a double whammy. Therefore, it will be prudent to expect a recession sooner than later. We have covered this topic in greater detail in our earlier article, “Will the Fed’s actions push the US into a recession”.

So, should the investor stay out of the equity markets completely?

No, because, no one knows when the current bull trend will end. Calling a top in a strongly trending market is next to impossible. Even Warren Buffett has not sold his core holdings because the market is overvalued. It is just that he has not done any fresh investments in the markets.

Due to the size of his investments, Buffett’s avenues are limited. However, as small investors, we have no such limitation.

The three ways an investor should approach the stock markets

If you stay out of a bubble completely, you can lose an opportunity to profit from the vertical rally just before the bubble bursts. Therefore, we recommend trading in stocks that are in momentum with an attractive risk/reward ratio. As these are momentum plays, traders should maintain strict discipline and respect their stop loss. However, due to the risks involved, the allocation size should be less than half of normal.

The second way to invest money during a bubble is to do it smartly. Due to the herd mentality among traders, most chase the sectors that are offering strong returns, thereby neglecting the underperformers.

At times, these beaten down stocks become dirt cheap and can be purchased for the long-term with minimal downside risk. However, investors should look closely at the company’s fundamentals before choosing a stock that is out of favor, because every underperforming stock is not a buying opportunity.

The third way is to wait for a confirmation of a market top and thereafter short the vulnerable sectors and stocks. Nevertheless, shorts should be initiated only after the markets turn decidedly bearish. Here too, the traders will have to maintain a strict discipline because short selling without an appropriate stop loss is a recipe for disaster.

So, shouldn’t you keep any cash at all?

As the market is not offering many opportunities, it is a good idea to keep about 30% to 40% of your portfolio in cash in the current market conditions because a correction of more than 10% will offer many opportunities to the astute investor to buy stocks at attractive valuations.

It’s apt to end with a Warren Buffett quote: “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”

Important: Never invest money you can't afford to lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here.



Feedback or Requests?

6 Comments

6 Comments

  1. embersburnbrightly

    September 3, 2017 at 12:21 pm

    Excellent article!

    • Rakesh Upadhyay

      September 4, 2017 at 8:07 am

      Hello embersburnbrightly,

      Thank you. I am glad you liked it.

  2. hoodun

    September 3, 2017 at 10:16 pm

    Tether is my cash.

    • Rakesh Upadhyay

      September 4, 2017 at 8:12 am

      Hello hoodun,

      If you plan to park your cash in an asset, technically, that is again an investment, which carries a certain amount of risk. Therefore, it is not similar to holding cash.

  3. bens

    September 12, 2017 at 8:49 pm

    “The second way to invest money during a bubble is to do it smartly. Due to the herd mentality among traders, most chase the sectors that are offering strong returns, thereby neglecting the underperformers.

    At times, these beaten down stocks become dirt cheap and can be purchased for the long-term with minimal downside risk. However, investors should look closely at the company’s fundamentals before choosing a stock that is out of favor, because every underperforming stock is not a buying opportunity.”

    =============== Can you give an example of an under performer that fits the criteria in which you are referring to? ==============

You must be logged in to post a comment Login

Leave a Reply

Economy

Tax Cuts and the US Stock Markets

Published

on

The stock markets rise or fall on sentiment, earnings, and economic data. While the initial boost following the US Presidential elections was sentiment driven, the markets held their own as the data flow stabilized and improved in the US and around the world. However, at the current levels, the US stock markets look pricey compared to historical averages.

// -- Discuss and ask questions in our community on Workplace.

Key points

  1. The markets are trading at rich valuations even after discounting a favorable tax cut
  2. Treasury Secretary Steven Mnuchin believes market will crash without a tax reform
  3. A few analysts believe that the markets will remain firm even without a tax cut
  4. We believe markets will be vulnerable for corrections if Republicans fail to pass the tax cuts
  5. Buy the rumor regarding tax cuts and sell once the news of a tax reform is announced

Nevertheless, the hopes of a tax reform have kept the markets buoyed. How much can these tax cuts add to the markets and what is the risk if the reforms are watered down or just don’t see the light of the day?

Analysts expectations for the S&P 500

// -- Become a yearly Platinum Member and save 69 USD and get access to our secret group on Workplace. Click here to change your current membership -- //

The S&P 500 is expected to end 2017 with earnings of $131 per share, increasing about 10% over 2016. For 2018, analysts expect the S&P 500 companies to collectively earn $145.2 per share.

However, there are differing views on whether these figures include the benefits accrued from the tax cuts or not. If the tax benefits are incorporated, then to what extent.

The most bullish analyst on the street, Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, believes that about $9 of $145.2 in the earnings projection is based on the benefits arising out of a tax cut. On the other hand, the most bearish analyst, Weeden & Co.’s Mike Purves, believes that $14 per share is from the tax cuts.

Let’s take a bullish scenario.

Analysts expect the annual per-share earnings to increase by $15 if the corporate taxes are cut from 35% to 20%.

However, Wilson has only accounted for $9 in benefits from the tax cuts. Therefore, we will have to add another $6, which gives us a figure of $151.2.

So, in the most bullish scenario, at 2580, the S&P 500 is trading at a forward p/e of 17 times.

Factset data shows that the 5-year average and 10-year average forward earnings P/E ratio of the S&P 500 is 15.6 and 14.1 respectively. Therefore, even with the most optimistic scenario of earnings built in, the S&P 500 is currently trading above its past averages.

However, just because its current valuations are above the historical averages will not cause a correction in the markets. But, can a failure to pass the tax cuts start a fall?

What if the tax cuts don’t see the light of the day or are diluted in their effect

Again, we shall consider the most bullish scenario. If the Republicans fail to pass the tax reforms, then the earnings projection for next year will fall by $9, to $136.2. At that level of earnings, the S&P 500 is currently trading at a P/E of $18.9, which starts to look pricey.

What level was the S&P 500 trading prior to the two previous crashes of 2000 and 2007?

As seen in the chart sourced from yardeni.com, the S&P 500 is already trading at a higher forward P/E than 2007. This confirms that we don’t have the comfort of valuations behind us. However, we are still a distance away from entering into a bubble territory when compared with the forward P/E of 24, recorded during the heights of the dotcom bubble. Therefore, a crash might not be in the offing.

How much will the S&P fall if the tax reforms don’t go through

Here again, there are two schools of thoughts. While one says that a failure to ring in the tax reforms can easily plunge the S&P 500, others believe that the stock market is unlikely to fall more than 5%.

Treasury Secretary Steven Mnuchin believes that a lot is riding on the tax reforms. In a podcast with Politico he said: “To the extent we get the tax deal done, the stock market will go up higher. But there’s no question in my mind that if we don’t get it done, you’re going to see a reversal of a significant amount of these gains.”

However, Credit Suisse and Morgan Stanley differ, as they don’t see a market crash even if the tax reforms fail.

“The market rewarded firms with high effective tax rates for only three weeks post-election, but not since,” wrote Jonathan Golub, Credit Suisse’s chief U.S. equity strategist. “For that reason, we do not believe that stocks would be at risk if a deal isn’t struck,” reports CNBC.

In a note to its clients, Morgan Stanley has painted three different scenarios with no tax cuts, modest cuts, and substantial cuts.

Morgan Stanley believes that the markets will only fall by 1% if the tax cuts don’t happen.

What do we believe?

We believe that the US market rally in the past year has been driven by hopes of a fiscal boost and tax reforms. These have kept the sentiment positive. As a result, the markets have risen on favorable economic data in the US and around the world and has not given up ground even when the news was unfavorable.

However, after failing to repeal Obamacare, if the Republicans fail to push through a meaningful tax stimulus, the sentiment will be dented.

That will leave the markets vulnerable to sharp drops on any adverse news because the floor of the reforms and an earnings increase will be lost.

On the other hand, if the tax reforms are announced, the markets are certainly likely to surge in the short-term, however, the bump up is unlikely to last for more than a few weeks. Usually, experienced traders buy the rumor and sell the news. We expect the same to repeat once the reforms are announced.

The markets will correct and the focus will shift to the effects of the stimulus at this stage of the recovery, which has been questioned by many economists. The Federal Reserve may also have to tighten at a faster pace than expected, which may neutralize some of the effects of the rate cuts.

Bottom line – To buy or to sell?

Buy the rumor of a substantial tax cut. However, once the cuts are announced, please book profits in the ensuing buying stampede.

On the other hand, if the tax cuts fail to materialize, keep the buy list ready to enter on any fall, which is closer to 8% to 10%.

Featured image courtesy of Shutterstock. 

Important: Never invest money you can't afford to lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here.



Feedback or Requests?

Continue Reading

Economy

U.S. Nonfarm Payrolls Unexpectedly Decline in September

Published

on

The U.S. job machine slowed significantly in September, as Hurricanes Harvey and Irma ripped through the southern states, disrupting local economies in their wake.

// -- Discuss and ask questions in our community on Workplace.

Overall nonfarm employment fell by 33,000 last month, following a revised gain of 169,000 in August, the Department of Labor reported from Washington. Analysts in a Bloomberg survey forecast an increase of 100,000.

The jobless rate declined to 4.2% even as workforce participation rose. That’s a level not seen since 2001.

Signs of wage inflation were present last month. Average hourly earnings rose at a faster 0.5% on month and 2.9% annually, official data showed.

// -- Become a yearly Platinum Member and save 69 USD and get access to our secret group on Workplace. Click here to change your current membership -- //

Earlier this week, payrolls processor ADP Inc. said U.S. private sector employers added 135,000 positions last month. Economists had projected 98,000.

Hurricane Harvey made landfall in Texas at the end of August, triggering the biggest weekly spike in jobless claims since 2012. A total of 298,000 Americans filed for state unemployment benefits in the week ended Sept. 2, a gain of 62,000 from the week before.

September was the first negative reading on payrolls in seven years. Hiring is expected to rebound in the fall as the states of Texas and Florida resume cleanup efforts in the wake of hurricane season.

Solid employment growth has been one of the few mainstays of the U.S. economic recovery, prompting the Federal Reserve to gradually normalize monetary policy. The Fed is widely expected to raise interest rates again before year’s end. The Fed’s “great unwind” of its balance sheet will begin this month at a rate of $10 billion.

The report had no immediate impact on the currency markets, with the U.S. dollar index (DXY) rising gradually shortly after the data were announced.

«Featured image from Shutterstock.»

Important: Never invest money you can't afford to lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here.



Feedback or Requests?

Continue Reading

Economy

BOJ Rate Decision: Bank of Japan Keeps Policy on Hold After September Meeting

Published

on

The Bank of Japan (BOJ) has voted to keep its trend-setting interest rate at record lows, as policymakers continue to rely on record stimulus to keep the economy humming.

// -- Discuss and ask questions in our community on Workplace.

BOJ Policy Decision

In an 8-1 vote, the BOJ kept its benchmark interest rate at -0.1%, where it has stood since January 2016. The decision was widely expected by economists, who say the BOJ is unlikely to budge on monetary policy anytime soon.

The BOJ also maintained its purchase of Japanese government bonds (JGBs) so that the 10-year JGB yield remains at zero percent. Meanwhile, annual bond purchases continue to be held at ¥80 trillion.

The BOJ shifted course on monetary policy last September when it made yield-curve targeting its central concern. Since then, it has been status quo.

// -- Become a yearly Platinum Member and save 69 USD and get access to our secret group on Workplace. Click here to change your current membership -- //

Economic Picture Brightens

Central bankers have been largely hands-off to let monetary policy do its job. Recent data suggest ultra-loose policies are finally having their desired effect. Japan is currently in the midst of its longest period of uninterrupted growth in more than a decade. Quarterly gross domestic product (GDP) expanded 0.6% between March and June, the fastest in more than two years.

In annualized terms, the economy expanded 4% in the second quarter, official data showed. That was much bigger than the 2.5% annualized gain forecast by economists.

Japan has now been on the right side of growth for six consecutive quarters and nine of the past 11.

Strong domestic demand and a synchronized global recovery lifting Japanese exports have been the main factors behind the growth.

Despite solid growth, inflation continues to lag the central bank target of 2%. Core inflation rose in July for the seventh straight month, but came in at just 0.5%. National CPI also expanded 0.5% annually in July for its seventh straight gain.

Inflation has been so disappointing that the BOJ recently postponed its inflation deadline for the sixth straight time. The move highlights the growing frustration with low inflation under the Abe regime.

Yen Losing Ground

Japan’s currency declined again on Thursday to trade at fresh two-month lows. The dollar-yen (USD/JPY) exchange rate reached a session high of 112.65 before paring gains. At the time of writing, the pair is up 0.2% at 112.51.

The yen has been in free-fall for the past two weeks as risk sentiment returned to the financial markets. The yen is a highly liquid reserve currency that usually receives strong bids during periods of instability. With investors pouring money into stocks, the yen has fallen by the wayside in recent weeks.

Important: Never invest money you can't afford to lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here.



Feedback or Requests?

Continue Reading

Trending