Why I'm Taking Risk Off The Table And Raising Cash

Nicholas Ward

This is a piece that I’ve been mulling over for a few weeks now. If you’ve followed my trades recently, you’ve seen that I’ve been trimming/selling shares to increase my cash position. Due to a variety of variables now facing the market, I’ve decided to take some risk off the table. My goal is to reduce my equity exposure from ~95% a few months ago to ~80% in the coming future.

Every time I write an article about selling shares I get a much higher percentage of negative feedback than I do when writing bullish articles on stocks. It’s as if many retail investors, for whatever reason, think its perfectly okay to make trades when you’re buying shares. This makes you an “investor”, with is oftentimes an abstract term thrown around to bolster egos and even justify mistakes. But, when those trades result in reduced equity exposure, an individual is no longer an “investor” but instead a “trader” which is akin to a traitor to that abstract cause. Everyone is entitled to an opinion and I respect that. The problem with critiquing moves and broader strategies in the stock market is that it will take years, or even decades, to truly prove whether or not moves made in the present were successful.

Speaking of decades, I’m well aware of the long-term compounding power of the market. I’ve read numerous stories and anecdotes of investors who’ve held stocks for decades on end and are not wealthy because of it. I firmly believe that there is no better tool, in terms of probability and reliability, of generating wealth in today’s society than the U.S. stock market. In a day and age where one could successfully argue that the “American Dream”…you know the one I’m talking about, where the hard working janitor works his way up the ladder into the c-suite, allowing his family to climb the social ladder, is dead. I hate to say it, but the way I see it, it’ true. So many things have changed from the halcyon days of single income blue collar households landing squarely in the middle class. I pay so much attention to the stock market because I believe that it is one of the last ways for the average low/middle income American to climb this social ladder.

That’s exactly why ~85 of my wealth is invested at the moment. It’s exactly why the vast majority of my holdings are dividend growth holdings; the compounding power of that snowballing passive income stream is what I plan to use to reach financial freedom. However, I’m also well aware of fundamental valuations and the fact that the market has been running hot relative to both recent and long-term historical norms lately and that unrealized gains can easily turn into losses should the market sentiment shift.

For years I’ve tried me best to view the stock market as just that: a market of individual stocks, ignoring the macro noise and focusing on individual quality and value. I still think this is the proper way to analysis stocks, though I also acknowledge that it’s impossible to view equities in a vacuum, especially in this modern market where passive investing and algorithms drive much of the equity exposure and trading on a day in and day out basis.

For the last decade or so the bull market has always faced numerous threats; we live in an imperfect world and there will never be a time when markets or economies operate without risk. Human nature itself is one of fear and greed, which ultimately results in long-term cycles. We’ve seen these play out again and again, almost to the point that they’ve become predictable. Granted, no one knows the exact time or day that a cycle will turn, but there are data points that seem to point towards the likely age of a developing cycle.

With this in mind, the FED has been and remains that biggest driver of the markets. The FED was responsible for much of the bullish sentiment in recent years with easy money/low rates bolstering earnings and driving up the multiples that investors were willing to pay for stocks due to their attractiveness relative to fixed income whose yields have been well below long-term averages. For years, investors have said, “don’t fight the FED” with regard to easing and I still think the FED holds the cards with regard to the future of the bull market. Jerome Powell seems to favor continued slow and steady rate increases, which I view as the most viable way to normalize rates without disruptive economic growth; however, I think that tax reform could overheat the economy and force his hand and any unexpected uptick in the normalization process could easily re-rate the market, causing multiples to contract. What’s more, it’s still up for debate whether or not Powell will uphold the “FED put” that former chairmen/women have enacted, stepping in front of bear markets when it may or may not have been aligned with the FED’s stated mandate.

The market’s fundamentals are based widely upon economic growth and with unemployment already so low, I think it’s clear that we’re drawing close to the end of the current economic expansion. Historically, the productivity required to spur economic growth has come from increased labor force participation. If we’re not already at full employment, we’re darn close. As we near 4% unemployment, it seems clear that we’ll have to transition our productivity model from a worker based platform to one based upon automation. The disruptive technology to make this happen is coming in the medium term; however, this presents another set of complicated issues regarding job losses and wage deflation as demand outweighs supply in the labor force.

The potential for the FED contracting multiples remains a medium-term threat, in my opinion. Like I said before, the market has been dealing with this threat for years now and thus far, the FED has done a great job of moving towards a more normalized interest rate environment without too much disruption on the equity front. I think the current market multiple makes sense in a ~3% 10-year environment. It would take a much more aggressive fed to push rates up to the ~4% area where I think equities would really suffer based upon their current valuations. However, there are a couple of short-term issues that have added their weight to the risk side of the scale recently, causing my viewpoint to shift a bit, towards a more moderate viewpoint, rather than the very bullish mindset I held coming into 2018 based primarily upon tax reform.

First of all, we have the trade war rhetoric coming out of the White House. Now, before I get started on the next two bearish viewpoints that I have, I want to preface them with this: I do not mean to come across as politically judgmental. It’s undeniable that policy moves markets, so it’s impossible to discuss investing, especially in this day and age of a very volatile Washington, without discussing politics. However, I’m doing my best to view these policies through a portfolio management lens and not a personal preference one. I’ve always agreed with Warren Buffett (and others) and intermingling politics with portfolio management isn’t a good idea. The markets are about profits; it’s my goal to grow and protect my wealth when I’m looking at my portfolio, so personal bias has little place to exist here.

I say all of that because I do not want the discussion that follows the conclusion of this piece to revolve around divisive politics. I actually think the political polarization is a major problem in this day and age and contributes to the growing animosity and divisiveness of our society. My goal isn’t to propagate a political debate, but to instead focus on risk management and asset allocation in a volatile/late cycle economic environment.

The reason that rumors of a potential trade war worry me so much is that neither Donald Trump nor Xi Jinping seem willing to back down and I fear that this desire to “win” will result in pain for the markets and the citizenry of both countries. In the short-term, no one wins a trade war. I agree with the President that intellectual property rights must be protected, though I’m not sure that a tit for tat tariff battle is the way go achieve his desired results. China is a communist nation and has a leader that doesn’t have to face re-election…you tell me which country will be willing/have the political will to dig in its heels and take the pain necessary to “win” this war.

Unilateral action seems unnecessary here and I can’t help but believe that any dialog backed by a broader coalition would carry more weight than the leverage the Unite States can create on its own. We’re obviously not the only country that is upset with China’s business practices and I’m sure that it wouldn’t have been difficult to create a like-minded coalition regarding Chinese trade. I know that coalitions aren’t typically Trump’s ideal situation, though history shows that China is a proud nation and as powerful as we are, I’m not sure if the U.S. has the clout to sway that Nation’s opinions/actions on its own.

Trump has touted the market’s wonderful performance during his tenure in the Oval Office as if it was the report card. Regardless of whether or not I agreed with the policies his administration was enacting, as an investor, this willingness to acknowledge equity returns as some sort of performance benchmark has given me peace of mind. It’s allowed me to overlook overheated valuations, focusing instead of pro-growth policies. However, this peace of mind was lost late last week when the President mentioned that investors may have to experience pain to achieve the long-term results he wants regarding China. With many of the globalists and free traders out of the White House, the POTUS is now surrounded by individuals hanging on to protectionist ideologies. What’s more, Trump also seems to the pandering to his core base now, more than ever, as well. This base doesn’t have a ton of well wishes for Wall Street.

This doesn’t bode well for Wall Street, nor does Trump’s impulsive style. The POTUS likes to keep people on their toes. It’s apparent that he views this as an effective negotiation strategy. This may be true; only time will tell how his major negotiations (NAFTA and Chinese trade) will work out. However, the market certainly doesn’t like uncertainty and investors won’t be willing to place such high premiums on equities during a risk-off environment due to these unknowns.

At this point it’s clear that Trump isn’t going to change. The market has been willing to ignore his impulsiveness thus far because oftentimes there’s a lot more bark than bite; however, as he gets back into a corner by foreign powers (China) or the domestic electorate during the November mid-terms, I can imagine him becoming even more outlandish and at a certain point the market’s numbness is going to break.

This leads me to another potential risk I see in the short-term: the potential for a democratic sweep of the house and Senate which effectively turns Trump into a lame duck. If this were to happen, it would surely hurt the likelihood of continued deregulation and pro-growth economic policies that Wall Street loves. It’s also worth acknowledging that with so many controversies surrounding the President, the likelihood of impeachment increases significantly in the event that the house and senate are blue instead of red. I can’t imagine that the market would react very well to this sort of potential political upheaval.

And lastly, speaking of political upheaval, the last, and potentially largest threat that I seem looming on the horizon is the Mueller investigation. As Mueller continues to zoom in on Trump, his family, and his businesses, I think it’s more and more likely that the President lashes out against the special council. This afternoon we found out that Trump’s lawyer’s offices were raided by FBI agents. If I know one thing about the POTUS, it’s that he doesn’t like to be attacked…and when it happens, he typically counter punches.

It’s becoming increasingly difficult to connect the dots regarding the administrations actions in Washington D.C. There has been speculation as of late that the President’s unwillingness to dismiss EPA commissioner Scott Pruitt amidst his recent scandals could be related to the idea that the POTUS is considering replacing embattled Attorney General Jeff Sessions with Pruitt. Pruitt has seemingly unwavering support from Trump’s core base. It’s unclear at this point in time whether or not Pruitt would have to recuse himself from the special council’s investigation, but it seems apparent that Sessions is not willing to support the President’s rumored wishes to fire of Mueller and if Pruitt would, then I think the President might open a can of worms that would result in an existential crisis for our democracy as a whole, resulting in protests that dwarf the Women’s March and uncertainty that would surely cause the market to sell off.

Another potentially large domestic issue is the privacy issues that we’re starting to unfold with regard to the F.A.N.G. names, which have driven much of the market’s success in recent years. If the F.A.N.G./information technology trade rolls over, it will be difficult to find a replacement sector/industry capable of pulling the same sort of weight. This is a short-term issue that our country and the world is about to sort through, and longer-term, we have the CBO’s estimates regarding U.S. debt growing to 100% or more of GPD in a decade or so if we stay on our current growth/spending path. The U.S. hasn’t seen a debt/GPD ratio like that since the end of World War II and I’m not sure if we have the same capacity for growth now that we did back then to eventually make up for it.

When I stack up these domestic issues against geopolitical headwinds coming out of the Middle East, North Korea, and Russia, I realize that tax reform and the idea of synchronistic global growth may not be power enough to keep the bull market afloat. In 2017 the market experienced tremendous returns, but multiples expanded because the fundamental growth did not keep up pace with the stock market’s. Tax reform will certainly be a boon for 2018 earnings, but I’m starting to think that the 2017 rally was essentially taking from Peter to pay Paul with regard to 2018’s likely returns.

Best case scenario, I see limited upside and a likelihood of sideways trade as interest rates continue to rise and the market’s multiple comes back in line with historical norms and worst case scenario, I see a one of these known issues blowing up into a black swan that brings down markets because the market has discounted its probability and/or significance of scale.

I don't have a time table for putting the cash that I raise back to work. Looking at my portfolio I have both buy and sell thresholds for each of my holdings and if they're hit, on either side of the spectrum, I will act accordingly.

Either way, I think it makes sense to reduce exposure from being nearly fully invested and raising cash so that I’ll have an opportunity to take advantage of any significant weakness should it arise. A decade into a bull market run, I’m not trying to be greedy; is this really the time to have all of your chips laying on the table? Playing defense now makes more sense to me than it has at any other time during the previous 6 years that I’ve managed my portfolio. Time will tell if my gut feeling regarding reducing risk is right, but even if I’m wrong, I’ll still benefit in a large way from the continued bull market with ~85 of my savings still tied up in equities.

So, with all of my concerns laid out on paper, I’m interested to hear your thoughts as well. Are you concerned about any of these issues? Do you think it’s all just noise? What are you plans for dealing with the changing tides when the bull eventually becomes the bear? It’s bound to happen at some point in time. What is an appropriate cash weighting, in your opinion? Obviously everyone’s risk tolerance/goals for their portfolios will be different, but I think it’s important to have these asset allocation discussions as we all attempt to learn and grow as portfolio managers.


Portfolio Management