Investors are frightened. Having lived through two brutal bear markets in a decade, this is not hard to understand. Recently, we’ve all had to contend with political inertia that has bordered on dysfunction on both sides of the Atlantic. In times like these, it’s not surprising that more and more investors are moving into cash. But that move may be a mistake.
To be sure, if there is a worsening crisis in Europe or we have another severe recession, investors will probably be better off out of the market for a period of time. But unless you feel confident that you can predict these events, it’s worth considering three reasons to keep some equity exposure.
1.) The Difficulty of Market Timing: Even for professional investors, market timing is extremely difficult. As the chart below illustrates, had you missed just the first 20% of the market recovery in 2003 — an achievement most professional investors would have been proud of — you would have underperformed staying invested in both the downturn and the recovery by nearly 10%, assuming an initial investment of $100,000 in March 2000 and investment period through February 2006.
2.) The Costs: Going to cash is not a costless transaction, particularly if you keep a large portion of your assets in cash for a prolonged period. Even in a low inflation environment, the dollar’s value will erode over time. Consider that since the mid 1980s — when inflation has averaged less than 3% — Americans have still lost 50% of their purchasing power through rising prices. While holding cash will protect the nominal value of your money, holding cash in today’s environment of zero interest rates means losing real value.
3.) The Valuation Argument: While there are no shortages of reasons to be pessimistic about the global economy, equity market performance is less about absolute conditions and more about how those conditions compare to expectations. In other words, if stocks are cheap enough, they may provide a good return even in the face of a lot of bad news. Today, global stocks are trading for around 12x trailing earnings. Historically, valuations have been roughly 75% higher. While a lot could go wrong, much of the bad news already appears to be reflected in the price of stocks.
While none of these reasons mean that markets will move higher in the near term, they do suggest that moving to cash is neither costless nor riskless. At the very least, moving a significant portion of your assets to cash will likely erode your purchasing power over the long term. At worst, moving to cash means you may miss out on a reasonable entry point, as stock valuations already appear to reflect a good deal of pessimism.