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The Smart Money Is Worried About Stocks and Hiding More Money in Cash. Should You?

Jul 22, 2016

With the S&P 500 and Dow Jones industrial average at all-time highs, you'd think that Wall Street would be rejoicing. But professional fund managers aren't exactly jumping for joy.

In fact, global fund managers are sticking more cash in the proverbial mattress than they have in 15 years. A recent survey by Bank of America Merrill Lynch found that professional investors are now holding nearly 6% of their assets in cash, on average.

This may not sound dramatic, but that's an even more defensive stance than fund managers took in the global financial crisis, which saw the biggest bear market since the Great Depression. This is also the highest level of reported cash since November 2001, during the bursting of the tech bubble.

Why is cash growing?

Part of this may be an attempt to safeguard their portfolios against a potential decline in the market now that stocks are at record highs, explains Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch Global Research.

For one thing, the bull market is now the more than seven years old, making it the second-longest rally in history. While there's no rule that bull markets die of old age, there is a feeling that after a seven-year run in which stocks have gained 200%, equities may be due for a downturn, if not a rest.

What's more, the market is getting more volatile—the S&P 500 lost more than 10% of its value earlier in the year, which is defined as a correction, and sank 5% in the immediate aftermath of the Brexit vote, which is defined as a pullback. Even though central banks around the world are holding interest rates at record lows to spark economic activity and risk-taking, investors understand that the stock market is historically expensive, which makes equities vulnerable.

And with prices getting frothy, "fund managers are having a difficult time navigating the investment landscape," said Jack Ablin, chief investment officer at BMO Private Bank.

So is everyone. But before you turn to cash, you have to understand certain aspects about today's market:

1) The fact that others are scared may be an argument for staying the course.

While a 6% cash stake is hardly a sign of terror, it is a measure of anxiety. And yet some financial pros see it as a contrarian indicator: According to Bank of America Merrill Lynch, whenever cash levels climb above 4.5%, it's viewed as a buy signal for equities. When cash piles fall below 3.5%, on the other hand, it means a lot of investors are getting confident—and to the contrarians on Wall Street, that's a sell signal.

2) Yes, there is some reason to be concerned...

Based on one traditional gauge of market valuations—which compares the price of stocks relative to 10 years of average corporate earnings—the S&P 500 is as expensive as it was leading up to the financial crisis in 2007. In fact, the market has gone through only three other prolonged periods where this "price/earnings ratio" climbed above 26, which is where it's at now.

Those times were: before the global financial panic, before the tech wreck in the late 1990s, and in the lead-up to the Great Depression in the late 1920s.

This doesn't mean that stocks are headed for another crash. But you can't ignore valuations as they are considered the best indicator of future long-term stock market returns.

And the frothiness of the U.S. market is one reason why the asset management firm Research Affiliates projects that domestic stocks will produce a meager annual return of just 1.2% — after inflation — over the next decade.

3) …but you don't have to turn to cash if you're worried.

While cash is considered a safe haven in a market storm, other assets can offer some ballast—without taking you totally out of the market.

For instance, you could simply boost your stake in bonds. To be sure, bonds are themselves trading at frothy prices—especially Treasury debt. But valuations are less problematic in high-quality corporate bonds issued by large corporations. And in the January market correction, in which stocks fell more than 10%, the Vanguard Intermediate-Term Corporate Bond Index ETF actually gained 1%.

You can also go with a balanced fund, which invests in a mix of stocks and bonds for you. The typical balanced fund holds about 60% of its assets in stocks and 40% in bonds, but fund managers often have discretion to tweak that mix based on market circumstances.

And yet another route is to focus on stock funds that have a strong track record for losing less in down markets.

Among domestic stock funds, a good example is Vanguard Dividend Growth . According to Morningstar, the fund has lost 28% less than the broad stock market in down months over the past decade. For foreign funds, check out Tweedy Browne Global Value , which has lost 46% less than the broad market in down months.

4) Finally, if you're really scared, raise some cash—but in moderation.

After a seven-year rally, there's no harm in taking some stock market profits off the table, especially if you have not rebalanced your stock-and-bond mix in a while.

But don't go overboard. The wealth management firm Asset Allocation Advisors, in Walnut Creek, Calif., has above-average cash stakes in client portfolios for defensive reasons—but by a modest 4 percentage points over normal. Asset Allocation Advisors also raised its recommended bond allocation by a modest 4 points, while lowering stock exposure.

The firm told its shareholders that "a lower-than-average allocation to stocks has maintained stock market participation, while shielding their portfolios from much of the stock market’s risk and volatility."

Notice they said shielding—not avoiding altogether.

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