Why Holding About 50% In Cash Equivalents Makes Sense For Investors Right Now (2024)

Introduction

Recessions and bear markets will occur as long as free markets exist. Pretending they don't exist or don't matter is not a good way to get better-than-average investment returns. And those investors who ignore the possibility of long bear markets in stocks are relying entirely on luck for their investment success. I don't like to rely entirely on luck for anything in life if I don't have to, so I pay attention when the dangers of recessions and extended bear markets are high. For nearly the past two years, I have written about why the dangers of a recession and a bear market in the US are high, and how I have adjusted my cash position because of those risks.

Here is how my cash position has progressed.

At the beginning of 2022, after being nearly fully invested in stocks by the end of 2021, I began getting more defensive in my portfolios due to a reversal of economic stimulus. Only three months later, soon after Russia's invasion of Ukraine in March 2022, I began raising cash in my portfolios, and in my article "How Much Cash To Hold With Russian Black Swan Risk Rising?" I explain the initial phase of cash raising. I continued to get more bearish on the market in May of 2022 and wrote a pretty comprehensive guide for how I prepare to invest during a recession in my article "Is A Recession Coming In 2022? What Investors Should Consider". Here is what I had to say about cash levels at the time.

I think less than 25% cash is probably too little, and more than 50% cash is probably too much for most investors who are looking to buy individual stocks in an unconcentrated portfolio, but that's just a rough guide.

At the beginning of this year, I thought investors should be prepared for a -30% decline in the S&P 500. Here is how the S&P 500 ETF (SPY) and the Equal Weighted S&P 500 ETF (RSP) have performed so far this year.

As you can see, neither one of them is down -30%, even though there is a big divergence between the returns of the two. In this article, I explain why I have roughly maintained my overall cash positioning this year. I still have about a 45% cash equivalent position in my individual accounts and about a 60% cash equivalent position in my 401k. I also explain why I think it is wise for most investors to have somewhere between 40% and 60% in 'cash' right now.

Why The S&P 500 Rally This Year?

Before we get into the likely reasons why the S&P 500 has rallied this year, it's important to point out that bear market rallies are normal and in my opinion, we are still in a bear market.

The above chart is of total returns since January 1st, 2022. It is important to keep in mind that in the US we have had about 12% inflation during this time as well, so in terms of actual purchasing power, we need to subtract about 12% more from the displayed returns above. The worst performer by far has been long-duration government bonds which have lost half their purchasing power in two years. These are often pitched as "safe" to investors or "ballasts" for portfolios. The best thing investors could have done is avoid these at all costs over the past several years. Even though the percentage decline in value isn't as bad over this period as Cathy Wood's utterly dismal Ark Innovation Fund (ARKK), the magnitude of losses in government bonds is probably in the hundreds of billions, which dwarfs ARKK in terms of total value lost, and I don't think even the most gullible investors ever though ARKK was "safe". Even if the value of these bonds ultimately recovers over the next two decades it's hard to imagine how inflation doesn't eat away at least half of the purchasing power.

Next, we see that Vanguard's Balanced Index Fund (VBINX), which is what I use as a 60/40 portfolio proxy is down -11%. Even the mighty (QQQ) and the ever-popular Dividend ETF (SCHD) remain in a bear market. Only my preferred cash equivalent, iShares Treasury Floating Rate Bond ETF (TFLO), has produced a positive return since January 2022, with a 6% return, which is still about -6% less than inflation, but it's at least close, and in 2023 TFLO's return has surpassed that of inflation.

Overall, my individual portfolios are down about -6% over this period even though I've been consistently adding growth stocks while maintaining about a 45% TFLO weighting. So, my overall defensive positioning hasn't caused me to suffer much since 2022 relative to QQQ and SPY, even with the bear market rally we have seen this year.

I think there are four main reasons SPY has rallied this year relative to the equal-weighted RSP. The first is that student loan repayments were successfully delayed by the Biden Administration for nearly two years until they finally resumed this month. These repayments will be a huge drag on the economy, and dramatically increase the odds of a recession each month as time goes on as this money is sucked out of the economy.

The second reason is there is a mismatch between short-term interest rates and rates that people and businesses were able to lock in for the long term when rates were very low. So, what has happened so far is investors in short-duration treasuries, money markets, and CDs, are now collecting about 5% interest, but those people like myself with a sub-3% fixed mortgage, or even people with 4% long-term fixed auto loan (which can now be as long as 6 or 7 years) are not paying higher rates, yet. In the short term, as a commenter on my last S&P 500 article pointed out, higher short-term rates can be stimulative. Personally, I think there are offsetting issues like student loan repayments and the types of spending patterns those different demographics of people tend to have (older savers with cash spend less than younger spenders with loan repayments in the economy), which I think will balance out this potential stimulative effect, or, at the very least, slow down the effect that higher short-term rates have on the economy. The bottom line is that it is taking longer for higher rates to slow the economy than I initially expected, but time is not on the side of the economy the longer rates remain elevated and more people and businesses have to refinance.

The third reason is that mega-cap tech companies were able to effectively cut costs much more quickly, and had much more fat they could trim, than I would have thought. When combined with their solid balance sheets, many of these mega-caps were able to improve their overall business quality relative to the rest of the S&P 500.

If you look at revenue growth from some of the biggest companies in the S&P 500 for the first six months of this year, they are on track to average about 6% or 7% revenue growth this year (not great, considering inflation is 3-4%).

Yet, many of the stock prices have risen 6x or more than revenues have. I think a lot of this has to do with cost-cutting for the ones that are up more than 30%. But cost-cutting can only go so far. Eventually, the top line is going to have to grow in order to justify the current valuations. This is going to be difficult to do in an economic environment that is facing nothing but headwinds going forward (not to mention complete gridlock in Washington).

And the last reason this handful of mega-cap tech stocks has rallied is AI and the speculation surrounding it. So, we have kind of experienced a speculative bubble in the middle of a bear market. Mega-cap, market-moving stocks like Nvidia (NVDA) and Tesla (TSLA) have participated in this rally. It remains to be seen how sustainable it will be over time. Both of these businesses are cyclical even if they are in secular growth industries.

In the end, none of the reasons for the stock market rally in mega-caps this year should be taken as a sign that the risk of a recession or the continued bear market is over.

Why 50% Cash Makes Sense

I will make a pretty simple three-part argument for why holding somewhere between 40% and 60% cash equivalent makes sense. The first part of the argument is the primary appeal of holding stocks from the point of view of a long-term or medium-term investor is that quality businesses have pricing power so if there is inflation, those costs can be passed on to the customers of that business. So, inflation protection is the primary attribute of quality stocks when compared to bonds. The primary attribute of cash equivalents like, CDs, money markets, and short-duration treasuries is that there isn't much, if any, price risk. You know what your return will be with cash, but what you don't know is how much will be left after inflation. This differs from the risk of owning stocks, which have the risk the price could fall and not recover over a given time period as well as the risk the business might not be as high quality as the investor expected.

Right now, short-term treasuries and high-quality stocks (as represented by the S&P 500) both have expected returns between 5% and 5.5% if we compare the earnings yield and growth with the yields on cash equivalents. I will note here that an investor needs to be able to 1) identify quality businesses, and 2) estimate the future earnings of those businesses over a given period of time, in order to make this comparison. This is something I do in my Investing Group, but Ray Dalio as recently as last week has publicly stated this same observation that cash and quality stocks have similar expected returns as well, so I don't think my estimates are too far off the mark given the information we have right now. The practical implication of this situation is that there is probably very little, if no, opportunity cost risk in holding cash-like investments if they are yielding between 5% and 5.5%, and they are liquid. Inflation has already fallen below 4%, so even in the event of an energy price spike, holding cash doesn't have much risk associated with it right now from inflation. Stocks, however, do have recession risk and risk associated with their high valuations, so the prices can certainly fall.

For demographic and geopolitical reasons, as well as due to the very leveraged nature of the US economy, I think there is a decent chance inflation will remain relatively persistent in the coming decade. There are too few workers and too much work that needs to be re-shored for defense and resilience reasons, along with an aging population, for the US to experience the deflationary pressures we've had during the past two decades. Unless we get world peace and stability sooner rather than later, that means the only way inflation stays persistently down is (1) through productivity gains (which might happen in some areas due to AI and automation but will not happen everywhere in the economy) or (2) a recession. I have termed this situation a "fragile stagflation", in which the normal state of affairs is the sort of stagflation we've seen the past 18 months, occasionally punctuated with slowdowns and recessions. What I don't see is a great boom of economic growth without inflation to go along with it.

When we put all this together, it makes sense to me to have a significant part of one's portfolio in the stocks of high-quality businesses that can pass inflation on to customers and also might be able to grow faster than average in a stagnant economic environment. These stocks will guard against the danger of stagflation. It also makes sense to have cash available to invest during the occasional recession or slowdown that comes along from time to time. I think it's only through avoiding some of the damage during drawdowns, and then capitalizing on the occasional cheap prices that might pop up that investors are going to be able to get returns over the next 5-10 years that exceed, say 2-3% more per year than inflation.

In short, cash and the S&P 500 offer similar return prospects right now over the medium term, but during a downturn, cash has the benefit of optionality that a person 100% invested in stocks (even quality stocks) does not have. Of course, for this strategy to work a person has to be willing to put that cash to work even if it's scary at the time.

Conclusion

I am often told things like "timing the market doesn't work" when I warn about the dangers of deep drawdowns and bear markets. But we don't have to time the market in order to see we've never had a time in history where both stocks and bonds were as richly valued as they were in January of 2022. At the most basic level, you can just look at the bond yields and dividend yields.

The above chart stops in January 2022. It doesn't require any market timing skills to look at those yields and understand they were inadequate compared to the inflation risk an investor was taking at the time.

Now, however, cash yields something. Times have changed. It doesn't require any market timing skills to see this, either.

Lastly, I'll close with a final chart. It's the performance of SPY and QQQ from the decade of 2000 to 2010.

This is what happened to investors who ignored valuations in the year 2000. They experienced more than 10 years of losses. But at least during this time period, duration bonds performed well and inflation was low. That is not the case during the current downturn.

Cash equivalents right now are investments. And relative to other investments in the market, they have a good risk/reward. The key danger of holding cash (inflation) can be balanced out by holding quality, growing businesses, as well in roughly equal parts. This strategy isn't going to make anyone rich, but it might be able to prevent one from becoming poor over the next 5-10 years.