ET Analysis: Cash turns out to be a safe harbour when market tide turns

Synopsis

Investors are increasingly holding cash due to concerns over high share valuations and market excesses. Despite criticism, including from Warren Buffett, many prefer the safety of cash or equivalents. Experienced investors are particularly cautious, while newer ones remain bullish. Cash holdings offer a cushion against potential market downturns.

Investors holding cash have been among the most dissed in the stock market of late. Equity evangelists are unable to wrap their heads around the fact that there is a segment of the market that prefers the safety of cash or its equivalent at this point over stocks that have extended their record-breaking run with the US Federal Reserve's interest rate cut - the first in four years - coming as a shot in the arm for bulls. Even the venerable Warren Buffett, who recently bolstered his cash chest to $280 billion, has not been spared the criticism.

The preference to move to cash among investors is mostly linked to discomfort over elevated share valuations and excesses in various pockets of the market. Anecdotally, the cash or equivalent holdings of many of these investors range from 15% to 50% of the total portfolio.

It's the more experienced, carrying the burden of having witnessed multiple market cycles, who have been nervous and maintaining higher cash balances. The relatively newer lot in the world of stock investing, who have stayed put because of their genuine belief in the oft-repeated bull market mantra -'This time it's different'- are seemingly laughing their way to the bank.

Most fund managers handling public money do not like holding cash and prefer staying fully invested in equity schemes. Their logic is that investors give them money to invest rather than keep it in cash. Moreover, these money managers are petrified that holding cash would lead to underperformance in a rising market. They are aware that when the market falls, the erosion of value will be broad-based, and they won't be singled out for bad performances.

So when market participants "hold cash", what does that mean? It does not necessarily mean they keep the money in low-yielding savings accounts. They put this cash for future deployment into stocks in relatively safer liquid products such as arbitrage, liquid and money market mutual fund categories. Then there are even those with a visceral aversion to debt instruments who believe money kept in liquid blue-chip stocks is equivalent to holding cash.

Sitting on cash is often one of the most painful aspects of equity investing. Investors - many of whom began increasing their cash holdings as early as late 2023 - have agonisingly watched the market climb from strength to strength with a more prolonged market fall proving elusive. While such instances have played out in the past, this time it could be even more painful as the reversal of the Fed's tight monetary policy cycle has possibly triggered a 'melt-up' in equities.

Notwithstanding the lost opportunity cost, making cash calls is not as bad a strategy as often portrayed. A reversal in the market never comes pre-announced. In a crisis, no risk asset is safe from a meltdown and sell-offs tend to be brisk and deep.

As Faisal Sheikh, managing director of London-based Monmouth Capital, wrote in a letter to the Financial Times newspaper:

"In our experience, real safety means simply 'not being forced to sell'. Logically, therefore, the rather mundane answer for ordinary investors is 'enough cash to see you through a crisis'. Even better if the cash means you can be busy getting on with your real life and not really notice the 'crisis' in financial markets."

One of the key risks in domestic equities currently is not entirely about staying invested or increasing cash holdings. It's the continued appetite for red-hot themes such as manufacturing, PSUs, infrastructure and railways, among others. Between May and July, equity funds specifically betting on these themes and sectors attracted about ₹60,000 crore, out of the ₹1.12 lakh crore flows into equity mutual fund schemes. When the tide turns, such investment themes will be most vulnerable to sharp declines.

Billionaire investor George Soros' evergreen quote on investing and trading is particularly relevant: "It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong."

To sum up, cash holdings may seem counterintuitive in a rising market, but they are a necessary cushion when the tide turns.

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