Saturday, December 8, 2018

How much cash should you hold for the coming stock market crash?

It is 100% sure that we will have a stock market crash during one of these years or decades to come. Typically, we have a crash every 5 or 6 years. But it all depends on your point of view. Some call 1982 – 2001 the big baby boomer bull market. But let me tell you that there were a number of crashes or super-corrections exceeding losses of 20%. 1987, 1990 and 1998 come to mind. There were also years of flat or slightly down markets; often following years of excellent market returns. The super-corrections did give me the heebie-jeebies, always did. I was only happy in 1987 because I had hardly any money in stocks and so I could benefit from ‘buying stocks on-sale’. I had been overcautious during previous years still fearing my 1982 losses; just like many today sit on the sidelines because of 2008. The real crash will come when all those sideliners are in as well – that may still take a while. Yet, don’t even think that those ‘super-corrections’ are painless.
The big secret is, that over the long-term, that is 10 or 20 years, often we all make money. Stock market return as has been pointed out in this blog repeatedly, typically averages 7% plus inflation. This together with preferential tax treatment of dividends and capital gains makes stock market investing profitable. Yet there are ‘dead decades’! That is typically in terms of stock price appreciation, however, in the meantime you can keep on collecting dividends which are typically better than plain interest on an after-tax basis. 

Do you really need 60% stocks and 40% fixed-income?  Maybe, but it is only a tool to reduce your portfolio volatility. If you have a ‘weak stomach’ for temporary losses – and many do – then this may be a good strategy. But interest income in my books is the closest thing to government theft. You see, interest rates are high during high inflation and low during deflationary times. Ahh, you had this government bond in 1982 when inflation was 14% and interest rates were as high as 22%.  Wow, that would make you a lot of money, right? Wrong. You see interest rates are fully taxed; in those days around 50%. 50% of 22% is 11% after tax income. But inflation lowers the value of your principal (amount of loan) by 14% per year. That is a real interest rate loss of 3%!!! (11-14%)  Today you don’t get a tax credit for investing in a negative interest bond. Even if your interest rate was 2% today - something most GICs don’t even pay, then your after-tax return is 1%. Oops and then there is 2% inflation. Again, a negative real return. If you must have interest income the best place is your tax-sheltered TSFA and to a lesser degree (now it is getting complex) your RRSP. In my books and in today’s world, fixed interest (other than real estate – another story all together) is theft by your government and debtors.

Buy-and-hold works if you have a strong stomach. On the other hand, buy-and-hold doesn’t work at all. 😊 If you had bought in the late 1800s the stocks that made up the Dow Jones Industrial and held on, then you would have made virtually nothing. Today the last of the bunch, General Electric is biting the dust under a cloud of fraudulent or misleading accounting. If you collected dividends rather than reinvest, at least you may have had something.

The secret of the Dow is that it is managed by the editors of the Wall Street Journal. Every year it is adjusted by a tiny bit. Last year they finally replaced G.E. with a hot stock that has good promise to shine over the next decade or so. The same is true for many market indexes. As such, what is the difference between an actively managed stock portfolio, a mutual fund and an market index ETF?  In my books, 87% of actively managed portfolios and mutual funds are trying to keep up with the index but underperform thanks to commissions and MERs.

Having said that, those market index ETFs are untested in bear markets (because they are so new). However, a bear market is nothing more than a very large correction with ‘losses’ exceeding 20% from the most recent market peak. This is just a question of volatility if you have an investment horizon of decades. In that case, do you really need to have cash?
Yes, downturns nor market peaks are very predictable. That is why you may just as well only invest in companies that last and with growing dividends when you can get them at a reasonable price. If you find such a stock, then just buy whether it is a bull market or bear market as long as the price is right. The strange thing is that at least 50% of profits from dividend paying stocks comes from said dividends. The appreciation resulting in capital gains is when you sell, which like buying real estate may be decades away. The impact of the early bargain price fades over time.

With commodity stocks this is different. Buy low when nobody wants them. Don’t use stop losses because the commissions and taxes may kill you. Hold them until the next peak of the commodity cycle and sell them for mostly capital gains and if lucky with some dividend profits. This is where you need nerves of steel and just dumb arrogance. The roller coaster rides those stocks take you through is damn rough. In the down markets you never seem to be able to do anything right. And… it is not that price momentum will stay the same all the way to the top of the market. If you look at commodity legends like Ross Beatty or Rick Rule, they tell you to follow the commodity cycle and only invest in companies with proven management and a diversity of projects. If you don’t think that Buy & Hold is easy then don’t even try investing in commodities. You will get eaten alive!
You even have to watch out with Buy & Hold stocks because the underlying companies, like G.E., can go bad even after decades of good performance. Thus, how much cash do you need during a downturn?  

The answer my friend is blowing… eh… is dependant on your investment style and your personal needs. The two big things that leads to real losses is if you sell in a panic at or near the bottom of a market or… if the underlying company is about to go under – again think G.E. Buying into G.E. right now is probably like trying to catch a falling knife!

Some professional managers don’t like to hold cash at all: ‘my investors pay me to invest not to hold their cash’.  Or more like Warren Buffett who always seems to have a lot of cash on hand. I have tried to simulate portfolio performance for many different strategies. My conclusion is that if you stay out of the markets during bad times, you are likely to underperform because the extra appreciation you may get from buying low, disappears over the long term and you are losing out on dividends. You could though during bad markets collect those dividends and build up a cash hoard to buy additional stock at bargain prices during the down turn. Also, I recommend you sell risky or highly cyclical stocks (like commodities) when approaching a market top, adding to your stash of cash.
So how do you avoid forced selling of your investments. The answer is simple: you need cash to pay for your cost of living and cashflow to service your debt. Especially a lack of cash to service debt can become very nasty. You see many corporate managements are selling assets to repay debt. That is not for the benefit of the shareholders but rather for the creditors who want their money back. Often you see bad management selling those assets at rock bottom markets and that makes matters even worse. Think about it, the assets that are being sold often generate income. The idea is to pay off the debt and debt service costs out of the project’s cashflow and the rest is profit. Well if you sell at the market bottom nobody will buy your crappy assets because then they lose money as well. They want to only buy your best assets at rock bottom prices. That is why those poorly managed corporations are forced to sell off their cash-flowing assets and end up in a death spiral. The managers often get golden hand shakes, but the share holders end up with the losses.

The same is true when you sell of assets to get out of debt at the bottom of a downturn. You get a poor price and you lose typically cash flow (dividends). You just need to have enough cash to live through the downturn and cash to service your debts (which is not always easy so be careful – better safe than sorry). You also may have a minor cash reserve augmented with cash flow from dividends to take advantage of buying opportunities. And… when you buy, you are probably too early while you salivate at ‘bargains’ that may fall even further. Don’t buy those ‘bargains’ all at once. Do it in small steps and if it works then buy more. You may even lose value before the actual upturn occurs. Just look at the current downturns in uranium, gold or oil and gas; recovery always takes longer than you think. Don’t be in a hurry usually there is a better deal around the corner.
In my experience, cash management is most difficult if you have made a commitment to expenditures for a large project like building a new plant or a new residence. Because, often when you count on your portfolio to generate lots of cash you get hit by a downturn or it seems a downturn is just around the corner (like today). I know the large project is likely to throw of a good profit, but it is going to be offset by underperformance of the rest of the portfolio because you are holding so much cash. Oil companies can stabilize their cashflow by hedging production and many do – Canadian Natural Resources was a master at this when building their Horizon open pit mine. And I am pretty sure that when oil was recently hitting $70 to $80 per barrel they hedged again. Suncor hedges probably as well but they also are protected by their refinery operations which make right now huge profits. As usual Encana and Cenovus are the real suckers. Why? Simple. Encana and spin-off Cenovus managers are not business founders; they are mostly managers that climbed up through the bureaucracy; they are not real investors. Many have barely skin in the game. That makes a huge difference.

Think about your own portfolio in terms of running a business as a manager with lots of skin in the game. Maybe you should consider if you are afraid (or even if you are not afraid) to hedge part of your portfolio, for example by buying ‘put options on a market index’ to ensure that any investment losses are offset by gains in the options. But, insurance or buying put options do cost money. So how concerned are you about a real down turn?

That is why investing is always agonizing about ‘what is the right thing to do’. In the end the buck stops with you and nobody else. Take care of your portfolio and consider what the right amount of cash is for you.

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