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

“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.

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.

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.”

Author:
Rakesh Upadhyay is a Technical Analyst and Portfolio Consultant for The Summit Group. He has more than a decade of experience as a private trader. His philosophy is to use technical analysis for momentum trading and fundamental analysis for long-term positions. Rakesh likes to keep himself fit by lifting weights and considers himself to be a spiritual person.