Let’s talk about our cash reserves today. I feel a tiny bit of guilt because 7 in 10 Americans have less than $1,000 in savings, according to a recent survey by GoBankingRates. Hey America, wake up and learn about Financial Independence! You need to save more so you won’t be so dependent on your employers. Anyway, I’m sure our readers are in a much better position with their cash reserves. Please take the RB40 survey at the end of the post to see if I’m right!
Earlier this year, I decided to build up our cash reserves because the stock market valuation seemed too high to me. The stock market has been on a great run since early 2009, but the earnings haven’t kept pace with the price. The easiest way to value the stock market is to look at the price-earnings ratio.
P/E ratio = price / earnings for the most recent 12 month period.
The PE ratio is an important tool for investors because it will eventually revert to a historical mean in the range of 15 – 20. Currently, the PE ratio for the S&P 500 is around 25. That means earnings will have to grow by a large amount or the price will have to fall to get back in line to historical mean.
*Important* High PE ratio doesn’t necessarily predict a stock market crash in the next few years. The market could keep climbing higher for a while like in the late 90’s. Or the earnings could catch up with the price. High PE ratio just tells us that the stock market is more expensive than usual and the long term rate of return will be lower than usual.
Shiller PE chart
The Shiller PE uses 10 years average earnings in the denominator instead of 12 months.
I think more and more investors are getting jittery. I see more articles in the main stream media about the stock market being overvalued. Personal finance bloggers and investors like me are starting to scale back on new investments. It just feels like investors are getting more nervous, but it could be just me projecting my feelings onto the world.
I am a big believer of the buy and hold strategy (for the most part). Over the long term, a diversified portfolio of stocks and bonds should do well. I believe you have to stay invested through any market condition and avoid selling when the stock markets crash. We plan to stay invested in the stock market even if the S&P 500 drops 50%.
We are still adding to our investments regularly, but at a slower pace than usual. We are contributing to our 401k every month. However, I’m not buying much in our dividend account. High PE also means lower yields. I’d rather wait to buy in at a lower price point and shoot for more dividend income.
Example: Stock XYZ is $100 and pays out $3 in dividends every year.
- If I have $1,000, I could buy 10 shares now and receive $30 in dividend income annually.
- If the stock drops to $50, I could buy 20 shares and receive $60 in dividend every year.
Of course, you never know what the stock market is going to do next year. XYZ could double in price.
So that’s why I’ve been trying to build up our cash reserves. However, I am not working full-time anymore so it’s not easy. Let’s see how much cash we have at the moment.
- Checking and savings accounts: $49,200
- Money market funds: $7,200
- I Bonds: $5,200
So we have about $61,600 in our war chest right now. That may seem like a lot of cash, but you’ll see why that’s not true in a moment. Most of this pile of cash is already allocated toward something.
- $11,000 to our Roth IRAs. We need to contribute to our Roth IRAs before the next tax day in April 2017. We could put the money in the money market fund if stocks are still too expensive.
- $21,000 to our dividend portfolio. I’ve been putting off dividend reinvesting this year and the cash has been piling up. I’m comfortable holding off until the end of 2017.
- $15,000 property tax. Taxes for our primary residence and 2 rentals are due in November.
- $10,000 in emergency fund. We need to keep some cash to pay bills and deal with any emergency that comes up.
Wow, that’s $57,000 already allocated to various buckets. We only have an extra $5,000 to play with. See, it is tough to hoard cash when you’re not making a good income.
*Important* Our cash reserves are just a tiny part of our net worth. All this planning and thinking will have very little impact on our overall finance. So why do this? It gives me something to do. It’s really hard for me to sit still and “do nothing” when the stock market is so volatile. I’m messing with just a tiny portion of our net worth. I think a lot of investors will be surprised by a big stock market crash and they will do something dumb like dumping their stocks. By giving myself a sandbox to play with, I can be psychologically prepared for a big crash. Also, it gives me something to write about.
Cash deployment strategy
So how will I deploy our cash reserves? Here is my strategy. I’ve revised it a bit to be more incremental since the last post – Create Your Own Buy Low Strategy.
|S&P 500 drops from peak||RB40’s deployment strategy|
|15%||Invest 1/3 of cash reserves|
|20%||Invest 2/3 of cash reserves|
|25%||Invest all of our cash reserves|
|30%||Sell 1/3 of bond funds and invest|
|35%||Sell 2/3 of our bond funds and invest|
|40%||Sell all bond funds and go all in with stocks|
Notice what happens if stocks decline 30% or more. I plan to sell our bond funds and gradually move into stocks. We have about $170,000 invested in bond funds in our retirement accounts. This is the last bit of reserve we have and hopefully, we won’t need to use it.
Also, if I see a good deal on a dividend growth stock, I probably will buy into it regardless of what the S&P 500 is doing. Everything seems overpriced now, though.
What if there is no crash in 2017?
Of course, there is no guarantee that stocks will drop in 2017. Stocks could continue to climb higher like they did over the last few years. That’s fine with me because the bulk of our net worth is already invested. Our cash reserves is just a small part of our net worth. I will have to evaluate the situation again in 2017. If earnings improve and the interest inches up, then maybe we could revise the plan and start deploying some of our cash reserves.
Are you building up your cash reserves to prepare for the next big stock market pullback? Or do you have a better strategy?
If you spent more than 5 minutes figuring out how much liquidity you have, then you need to try using Personal Capital to help manage your accounts for free. Personal will aggregate all your accounts and give you an overall view of your savings and investments. Try them out if you don’t have an account.