Ian Cowie: Personal Account

Those concerned about the end of the bull run should consider building up a cash buffer rather than quitting the market entirely.

Choppy Waters

Choppy waters: when leading investors such as Warren Buffett appear to be gearing up for a stock market shock, it may be time to get your portfolio in order.

When the facts change, I change my mind — or so said the economist John Maynard Keynes. Perhaps more importantly for our purposes, Keynes was no mere academic but a successful stock market investor too.

So, in a spirit of humility, this long-term enthusiast for equities — or “bull”, in market jargon — had better report three factors that prompt a disturbing thought: it may be time to listen to the pessimists, or “bears”. While I continue to believe that shares and stock market-based funds will deliver higher returns than cash or bonds over most periods of five years or more — that is, after all, what has happened throughout the past century — current valuations near record highs suggest some caution is required.

For the avoidance of doubt, I am not saying sell everything and run for the hills, because, as repeated here many times over the years, this column has no crystal ball. Instead, it may pay to take some profits where prices have risen most and build a cash buffer against the risk of a stock market shock. More positively, that would also mean we can pick up bargains if share prices fall sharply.

There is no need to take my word for it. That is what the leading investor Warren Buffett is doing with Berkshire Hathaway, his $510bn (£395bn) US fund, which recently reported rising cash holdings.

This is the first of my “reasons to be fearful”. At 18% of assets under management, Berkshire’s cash position is not as high as it was on the eve of the last two big market shocks — it had 20% of its fund in cash just before the credit crisis went global in 2008, and 26% before the dotcom bubble burst in 2000 — but the warning light is beginning to glow.

Closer to home, another successful and wise asset allocator is expressing caution about frothy valuations and irrational exuberance in some parts of the market. Alan Steel, (Chairman of) the Scottish independent financial adviser and long-term bull, points to the rising popularity of passive or tracker funds.

Without wishing to get lost in the weeds, most trackers follow indices, such as the FTSE 100, whose constituent companies are chosen by size. That means money is flooding into the biggest shares, which have already grown the most, while cash is being withdrawn from out-of-favour sectors such as income or value shares. Unfortunately, buying high and selling low is the opposite of the usual way to make money. No wonder passive investment strategies are sometimes likened to driving a car by only looking in the rear-view mirror.

Worse still, amid talk of a trade war between America and China, storm clouds are gathering over the global economy. Steel told me: “In airline parlance, it’s time to fasten seatbelts in case there is turbulence ahead. That way, you won’t need clean underwear if it gets really bumpy.”

Bringing all this back down to earth, my third reason to be fearful is fresh investment analysis in America from Ned Davis Research showing how falling unemployment and rising Federal Reserve interest rates have tended to precede stock market shocks in the past. Unemployment in America is near its lowest level for 50 years and the Fed is widely expected to increase rates this autumn.  ……

……  Steel also suggests shifting the emphasis from growth to income — or away from funds and shares whose prime aim is capital gains and towards those paying dividends — as a way to reduce risk without giving up all exposure to future returns.  ……

……  At this point, it might be prudent to recall the dictum of the economist JK Galbraith that there are only two types of expert in forecasting the stock market: those who don’t know and those who don’t know they don’t know. Your humble correspondent is in the first camp and would never pretend otherwise.

However, with the current bull run for share prices already being the second-longest on record (the longest was 1990 to 2000), this feels like a good time for those of us who have enjoyed the ride so far to reduce risk and raise cash holdings — perhaps by taking profits and/or sitting on dividend income as cash, rather than reinvesting it straight away.

After all, a trend is only a trend until it stops. Or, as a wise sailor told me long ago, if you think it might be time to reduce sail, it is time to reduce sail. You don’t want to have too much canvas up if a summer squall becomes a gale force nine.

Ian Cowie