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Market value and cash levels.


petec
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We have had a lot of good discussions on whether it is worthwhile adjusting cash levels for general market valuation levels.

 

I have a conundrum.  On the one hand I basically believe in holding great companies forever.  On the other hand, I think markets look expensive here.  They look expensive on PEs, and they look extremely expensive on metrics that have historically done a much better job than PEs of predicting future long run returns (P/S, P/GVA, and others - I am taking this from Hussman whose numerical work I respect even if his calls have sometimes been wrong). 

 

I can't invest in individual securities - only collective vehicles - so I can't stock pick my way around expensive markets.  I can keep the individual stocks I do own, and I own long term survivors, but they are not cheap.

 

I am very tempted to raise cash.  This is a value call, not a macroeconomic prediction.  I just think the skew between risk and reward here looks unpleasant.  Several smart members on here have argued strongly against holding cash.  Does this advice still apply at current market values?

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I think the research paper that racemize performed suggested that you should remain invested as long as you still can find undervalued positions.

 

My take is that, even if the market is going loco, if there are still a few pockets of value, then it pays to stay invested in those.

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On the one hand I basically believe in holding great companies forever...I can't invest in individual securities - only collective vehicles - so I can't stock pick my way around expensive markets.  I can keep the individual stocks I do own, and I own long term survivors, but they are not cheap.

 

I was a little confused at first, but maybe I understand.  So you can no longer pick securities (I guess because of job conflict?), but you are allowed to choose sell (or not to sell) the ones you own?

 

Sounds like a nightmare in the current environment.  I would be very tempted not to sell the individuals if they are good, as it seems like you are restricted from rebuying them later.  I'd probably raise cash by saving current income if I couldn't pick any current securities.

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On the one hand I basically believe in holding great companies forever...I can't invest in individual securities - only collective vehicles - so I can't stock pick my way around expensive markets.  I can keep the individual stocks I do own, and I own long term survivors, but they are not cheap.

 

I was a little confused at first, but maybe I understand.  So you can no longer pick securities (I guess because of job conflict?), but you are allowed to choose sell (or not to sell) the ones you own?

 

Sounds like a nightmare in the current environment.  I would be very tempted not to sell the individuals if they are good, as it seems like you are restricted from rebuying them later.  I'd probably raise cash by saving current income if I couldn't pick any current securities.

 

That's exactly the dilemma.  Selling the individuals will pay off if there is a market selloff and I can reinvest in collectives at better valuations.  Otherwise it won't.  Not a pleasant decision.

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Sounds like a tough situation.  If you like the business you have & they are growing why not hold onto them until they stop growing or are really overpriced despite the growth.  I would use a valuation technique that includes the growth in multiple like P/E = (2g + 8.5) formula from Graham to evaluate if the stock is more overpriced than the market.  If you want cash raise it from current savings but realize the opportunity cost of cash today is still pretty high compared to history. 

 

Packer

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realize the opportunity cost of cash today is still pretty high compared to history. 

 

That's only true if you have great ideas to invest in.  I'm stuck with the market, in effect.  And the market is on a valuation that suggests prospective long run returns are poor and the downside if investors get scared is significant.  The opportunity cost of cash is therefore low, and the option value is high.

 

I will raise a little cash and let cash accumulate.  I have also set targets (using CAPE) at which I will raise more cash if valuations keep rising (subject also to the valuations of the individual stocks I hold).  CAPE should actually come down over the next 2y as the 2008-9 earnings come out of the denominator so these targets may well not trigger. 

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Trying to follow here versus the present opportunity cost of holding cash.

Opportunity cost can be a forward looking concept.

 

With inflation, bond yields and earnings yield being so low, historically speaking, why would the opportunity cost of holding cash be considered high now?

 

There must another explanation than fear of missing out? No?

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Opportunity cost is quite high regardless. It is possible stocks make 5%  for quite a few years before any big correction happens, and that is quite a lot of cost to overcome, even if you time it right.

 

I should note that while my thesis was that you should only invest if you have good ideas, it was taken from the view of a value picker. The data actually bore out to stay invested the whole time if you couldn't pick securities.  I tested lots of valuation-based models and none of them returned better than 100% invested. I even tried a few perfect hindsight models and those also underperformed.

 

So Petec, I've changed my mind--I think I would just do the same thing I tell everyone who isn't a value investor to do in your case. Hold and dollar cost average with income.

 

Or quit your job.  ;)

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realize the opportunity cost of cash today is still pretty high compared to history. 

 

That's only true if you have great ideas to invest in.  I'm stuck with the market, in effect.  And the market is on a valuation that suggests prospective long run returns are poor and the downside if investors get scared is significant.  The opportunity cost of cash is therefore low, and the option value is high.

 

I will raise a little cash and let cash accumulate.  I have also set targets (using CAPE) at which I will raise more cash if valuations keep rising (subject also to the valuations of the individual stocks I hold).  CAPE should actually come down over the next 2y as the 2008-9 earnings come out of the denominator so these targets may well not trigger.

 

Adding to my last post, I've tested CAPE based cash models and the returns are not good. I wouldn't recommend using that one personally.

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To be clear on CAPE, I am NOT using it as a timing tool, but as as a measure of valuations and future returns for the market given that I have to have general market exposure.  Hussman argues that P/S and P/GVA have 90% correlations with future nominal 7, 10, and 12 year returns.  Maybe I should use those instead but CAPE does have a strong correlation with future returns too.  The key point is that most of the valuation metrics I know of suggest the market return from here is likely to be low, and I want a preplanned selling discipline to reduce the chance that I will make emotional decisions (i.e. I want to sell on the way up, not the way down!).  I do the same with individual stocks and the market is just a collection of individual stocks.  Again this is not a comment on timing but just refers to the amount of risk I am willing to assume given the likely reward.

 

As for the opportunity cost of cash: I am quite happy to lose out on 5% a year for a few years before a correction for three reasons.  1) Including the correction, that sounds like a roughly flat market to me, and that's not a big opportunity cost. 2) My net worth is at a point where losses mean materially more to me than gains, so my focus isn't on eking out an extra couple of percent, it's on not taking risk unless there's a really good reward.  3) A serious inflation pickup would erode stock prices much faster than it will erode the value of cash, giving me buying opportunities.

 

As an aside, I was struck by a piece I read recently saying that all 45 countries monitored by the OECD are growing in 2017.  That's only the third time that's happened in >40 years.  We are looking at high valuations (record highs on some important measures), low inflation despite growth everywhere, record low interest rates, and record high margins.  Does that not look like the very definition of "perfection, priced in"?  What was it Buffet said about when to be fearful?

 

 

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Hussman argues that P/S and P/GVA have 90% correlations with future nominal 7, 10, and 12 year returns.

 

Hussman is the perfect example of why this strategy doesn't work. It's very easy to look at current prices and say that future returns are likely to be low. It is very difficult to time your re-entry so that this strategy pays off. In 2009, Hussman didn't even get back in when even wonderful growth companies like Apple and Google were trading at 15x. Hussman is super-smart. Why do you think you will do any better than he did?

 

You say that your "net worth" is at a point where your loss aversion is high. Why not just adjust to a more conservative asset allocation instead of trying to time the market?

 

The other option would be to add an allocation to emerging markets. These are still attractively priced. They will still fall during a market crash but at least the prospective return is high enough to justify the risk.

 

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Expected market returns going forward are still positive, they're just lower. So maybe expected returns are +4% instead of +8% or whatever. It sounds like your net worth is pretty high, but I don't understand why going from $10M to $9M (or whatever it is) during a temporary correction matters? The market is going up long-term. A correction is only a permanent hit to your net worth if you buy high, sell low, and don't buy back in for several years.

 

With that being said, your situation is an annoying one. I agree with racemize--throw money in an index fund and never look at it. It'll be worth a lot more in 20 years, that's all that matters.

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I wouldn't put a lot of of credence into Hussman, given his poor track record.  At some point he will be right, but over the long cycle, his approach does not seem to work.

 

Re CAPE specifically, it really appears to be a  case of fitting the 10 year chart to the S&P results.  See this - http://www.philosophicaleconomics.com/2014/06/critique/

 

Also, seems like most investors using CAPE as a tool the last few years have underperformed.

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Hussman is super-smart. Why do you think you will do any better than he did?

 

Because I did do better than he did!  I've no idea why he did not buy then: his valuation measures were all telling him to.  CAPE was at 13x briefly.  I'm interested in his stats, not his opinions!

 

You say that your "net worth" is at a point where your loss aversion is high. Why not just adjust to a more conservative asset allocation instead of trying to time the market?

 

That's exactly what I'm doing.  And I'll adjust it back if I see more reward for taking less risk (i.e., lower valuations).

 

The other option would be to add an allocation to emerging markets. These are still attractively priced. They will still fall during a market crash but at least the prospective return is high enough to justify the risk.

 

I have plenty of exposure there already!

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Expected market returns going forward are still positive, they're just lower. So maybe expected returns are +4% instead of +8% or whatever. It sounds like your net worth is pretty high, but I don't understand why going from $10M to $9M (or whatever it is) during a temporary correction matters? The market is going up long-term. A correction is only a permanent hit to your net worth if you buy high, sell low, and don't buy back in for several years.

 

With that being said, your situation is an annoying one. I agree with racemize--throw money in an index fund and never look at it. It'll be worth a lot more in 20 years, that's all that matters.

 

If my net worth was $10m I'd be on the beach.  It's at a point where gains are not spectacularly useful to me but losses are a problem.  Current market valuation levels have historically led to 10 year returns closer to 0% than 4% (that's total, nominal returns).  And there are several occasions in history where the market has taken >10y to regain prior highs.  That would have a material impact on my quality of life for those 10 years, so I don't see the risk/reward as attractive.

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Also, seems like most investors using CAPE as a tool the last few years have underperformed.

 

That's true of most value-based investing techniques.  Thing is, the longer value doesn't work the more it will work in the end!

 

Thanks to all for commenting - you've all helped me refine my thinking considerably which will, in the end, mean I am happy with my decision whatever the outcome.

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I wouldn't put a lot of of credence into Hussman, given his poor track record.  At some point he will be right, but over the long cycle, his approach does not seem to work.

 

Re CAPE specifically, it really appears to be a  case of fitting the 10 year chart to the S&P results.  See this - http://www.philosophicaleconomics.com/2014/06/critique/

 

Also, seems like most investors using CAPE as a tool the last few years have underperformed.

 

Not to discredit the argument that CAPE is a poor timing mechanism, but value metrics almost always underperforms at the end of cycles. Value as a whole has underperformed growth 9 out of the last 10 years in the U.S. (measured on a P/B basis). Underperformance over the past 9-years hasn't discredited value investing for most, so the underperformance of a CAPE strategy before the cycle is complete shouldn't be used to discredit it either.

 

All that being said, CAPE isn't a timing mechanism, but it has been a pretty good measure of forward-looking returns for most of its history. When CAPE is unattractive, it does not necessarily mean sell everything and hold cash. Simply sell the unattractive things and buy things that are more attractive. I've been in international stocks, EM, and resource companies for the last 4-years because they were much better valued. I have very little long exposure in the U.S. (autos and retail). Has this impacted my returns - absolutely! Up until 2016, the U.S. was trouncing EVERYTHING! Particularly growth stocks in the U.S. The last two years have been a bit more favorable for me, but I think the vindication will be made when the U.S. corrects.

 

Some people have said 10-years is the wrong fit for CAPE. They're right - when I ran the numbers correlations with returns myself, there was a higher correlation to 12- and 15- year returns (even though 10- is already a pretty compelling fit). This only suggests the implications of a high CAPE on future returns might be even LARGER than is currently understood and people may be underestimating how terrible forward-looking returns for U.S. equities could be - but it also extends the time frame in which a given correction in returns should be expected to occur by 2 to 5 more years.

 

 

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Also, seems like most investors using CAPE as a tool the last few years have underperformed.

 

That's true of most value-based investing techniques.  Thing is, the longer value doesn't work the more it will work in the end!

 

Thanks to all for commenting - you've all helped me refine my thinking considerably which will, in the end, mean I am happy with my decision whatever the outcome.

 

The best approach is to do this on a stock-by-stock basis rather than based on market levels. During 1999-2000, there were great bargains because so much cash was being sucked into dotcoms. But your trading restrictions make yours a unique situation so any advice here will be of little value.

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I think you're UK-based?  Are Investment Trusts ok for you to invest in?

 

If so, how about one of the absolute return ones like CGT or PNL?  I see them as usually doing better than cash, with low volatility, and pretty honest managers.  You could probably add RICA in there as well, though I'm less convinced by it.

 

If you don't mind adding to your EM exposure, you could look at one of the Vietnam ITs.  It's not as cheap as it was a year or two ago, but not crazily expensive.

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... I can't invest in individual securities - only collective vehicles - so I can't stock pick my way around expensive markets.  I can keep the individual stocks I do own, and I own long term survivors, but they are not cheap. ...

 

Please note Pete's discussion basis here, thank you. [: - ) ]

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I think you're UK-based?  Are Investment Trusts ok for you to invest in?

 

If so, how about one of the absolute return ones like CGT or PNL?  I see them as usually doing better than cash, with low volatility, and pretty honest managers.  You could probably add RICA in there as well, though I'm less convinced by it.

 

If you don't mind adding to your EM exposure, you could look at one of the Vietnam ITs.  It's not as cheap as it was a year or two ago, but not crazily expensive.

 

Actually yes I can invest in investment trusts (but not European holdings companies - go figure).  And guess which three I hold?!  CGT, PNL, and a little RICA, though I'm less convinced by it!  But the thing is they are not absolute return in the hedge fund sense.  They are absolute return in the valuation sense - they go long when they see value and hold cash or ST bonds etc. when they don't.  Today they hold roughly 40% equity and 60% ST bonds/cash, so selling equities to buy them is very similar, in asset allocation terms, to selling equities to hold cash.  So the original question stands.

 

I have seriously considered selling everything and putting it all in PNL and CGT. 

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For people who cannot (for whatever reasons) do individual stock investing, I often suggest Graham approach for "defensive" investors (chapter 4 of Intelligent Investor): stock/bond portfolio with allocation varying from 75%/25% to 25%/75% based on whatever reasons (valuation/macro/whatever). It's likely that most of these people would be better off with even more restricted Graham: 50%/50% or classical asset allocation 60%/40%. But if someone wants to play with market, the 75/25-25/75 swings may satisfy their hunger for "active investing".

 

(BTW, what the heck you do when both stocks and bonds are overpriced? I guess still the same...  8) )

 

I don't suggest racemize's 100% stocks, since people who ask for suggestion usually are afraid of stock market (or its valuation) already. Then 100% is just a recipe for either them not listening to me at all or for buy-high-sell-low-never-again disaster IMO.

 

I don't have any results of these suggestions though. I think most people don't listen to me anyway...  8)

 

Personally I have been at ~80/20 since ~2009-2010 or so, with 20 in cash and not bonds most of the time even. Yeah, I think now that I shoulda gone racemize 100% but I can't say I am unhappy with where I was/am.

 

FWIW.

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Can you invest in sector ETFs?  That might be the way I would play it - look for areas of the market you find attractive and focus there. The S&P itself is unattractive, but there are many reasonably valued companies in health care, large cap tech, retail, autos, etc. With so many new ETFs out there, you're bound to find a few that slice and dice the market in a way that makes for a more attractive package than the broad market ETFs.

 

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