One sign of a bear market bottom is said to be that cash is king.
- The idea is that if everyone is so terrified of putting money into risky assets that they’d prefer to hold cash, then all the sellers of equities have already been scared away.
Such times may be a good opportunity to buy shares for the long-term.
In contrast, in bull markets cash is trash.
- These are the times when you can get 7-10% from savings accounts, which is an excellent return comparable to the long-term return from stocks, and with none of the risk. Yet the stock market keeps rising!
At such times, the authorities have usually raised interest rates to try to dampen the boom. Yet everyone is greedy, sending stocks into bubble territory. You’ll even hear the phrase ‘cash is trash’ being used in newspapers and on TV.
If you hear people saying that, it may be a good time to strategically rebalance your portfolio in favour of bonds or cash.
Using cash as a guide to asset allocation
People are often tempted into trying to time markets, especially when the memory of a bear market is fresh.
Such timing is a difficult in reality, and you’ll often be better investing monthly through the highs and the lows for average returns, or rebalancing according to pre-set asset allocations.
Rebalancing allocations can trigger capital gains tax and cost you in fees, as well as lost returns if your timing is wrong.
But if you are going to try to strategically manage your equity exposure, then watching how investors treat cash at any point in time might be a useful tactic (alongside monitoring dividend yields and the average market P/E ).
For instance as I write in early 2010, you can get 4% from the best cash ISA savings accounts, which is far ahead of the base rate of 0.5%.
However, I wouldn’t say cash is trash just yet, because institutions can’t get anything like 4% from the short-term bonds they invest in as a near-cash equivalent. They currently get less than 1%.
They can get over 4% fixed from 10-year UK government bonds – a huge spread over short-term rates, but still not very attractive compared to 3.25% from the FTSE 100, given that dividend income should rise over time.
I therefore think it’s currently sensible to prefer shares to cash or bonds. For now, the yield situation looks good for equities.
Also, financial insiders are still reporting there is a lot of cash on the sidelines after people stopped investing in equities and other risky assets during the bear market. So even now, cash is king in a lot of investors’ minds.
Usually there’s very little cash around at the top of a market. In fact, people often start borrowing to invest – a classic sign of a toppy market! Again, cash is trash doesn’t hold right now on that score.
Lots of money was put into stocks in the latter half of 2009 and more will come in 2010. But I don’t think cash is trash quite yet.