I'm a Cash Contrarian

From time to time, I think it makes perfect sense to be less than fully invested in the markets. Although I'm not abandoning equities outright, I do think now is an opportune moment to focus my positions and, on a strategic basis, raise some cash.

Admittedly, cash has been a losing trade for some time. When stocks were soaring during the late 1990s, cash was trash. Then, when stocks tanked, bonds were the play. Regardless, money-market yields have hovered under 1% for months — making cash the one asset nobody wants to hold. That's why I believe now might be a good time to pad my portfolio.

Call me old fashioned, but I don't see the logic for people becoming investors unless they're virtually debt free and have a year's worth of living expenses sitting in the bank. The reality, unfortunately, is that many Americans not only fail to meet those criteria, but also aren't taking steps to get there. Witness the personal-savings rate, which was in the double digits as recently as the mid-1980s and now sits at just 1.3%, not too far from an all-time low. Although the statistic is criticized for not including equity and home appreciation, it does accurately depict how little cash most people have stashed for a rainy day.

Yet it's not only individuals who are less than liquid these days. Professional investors are essentially fully invested as well, at least as evidenced by statistics on mutual-fund liquidity. According to data from the Investment Company Institute, equity mutual funds hold roughly 4% of their assets in cash, down from double that during the mid-1980s and a recent peak of 12% in the early 1990s. Although the measure spiked a bit in the wake of the 2000 technology downturn, funds essentially have less cash on hand then they've had at anytime in the last 20 years.

My primary interest in building some cash right now isn't based on a belief that the market is going to collapse, but rather on an abiding desire to stay one move ahead of the herd — which, judging from the number of unsolicited penny-stock promotions I've been getting, is more intent on putting money to work right now than saving it. The fundamentals are also telling: Among pros and non-pros alike, the debate isn't whether a recovery is underway, but rather its size, speed and duration. Most people, I think, believe the bottom has been made.

While I'm not fighting stocks, I am diluting my concentration a bit and being more selective about those to which I devote new money. For example, sectors such as insurance and European stocks still appeal to me, and with a larger cash allocation, I find it even easier to hold my favorite stocks during turbulent or choppy markets.

Cash, like gold, seems to inspire all-or-none thinking en masse. People are either leveraged to the hilt in the QQQ (QQQ), or completely in cash with nary a stock in sight. But as I often point out, trading isn't always black or white. Raising cash doesn't have to require a complete portfolio purge.

Investors can build substantial reserves simply by eliminating the small "useless" positions that make up less than 1% of their assets. I last wrote about useless positions a year back. They're the immaterial and insignificant allocations that, even in the best of circumstances, won't have any serious impact on the bottom line. In a $50,000 portfolio, how much impact will 100 shares of Lucent (LU) really make? Even if the stock were to double in price, the effect on a portfolio would be minuscule. I think if you don't like a stock enough to have at least 1% of your portfolio pledged to it, it's probably not worth owning at all. Harvesting such mini-positions is an ideal way to add cash to a portfolio without dismantling primary trades.

In addition, one can easily set up a "cash drag," a strategy I last talked about almost two years ago. This involves investors directing their mutual funds to pay interest, dividends and capital gains in cash, rather than reinvesting them. It's a gradual way to dilute a portfolio without completely strip-mining favorite holdings.

Although the returns on cash might be dismal, some recent technical action suggests that a change could be underway. Bank-loan or floating-rate funds, one of the few fixed-income instruments that prosper during periods of rising interest rates, have been big winners in recent months. Also, although the Fed has signaled that rates are to remain low for some time, the CBOE's Short-Term Interest Rate Index has been resilient. Based on the discount rate of the most recently auctioned 13-week U.S. Treasury Bill, the index is an excellent measure of short-term rates and, it just so happens, isn't too far from a multi-month high.

I'm not a pessimist — I'm a professional obsessive compulsive. And although I don't shy away from risky investments, I plan for the worst and aim to be pleasantly surprised. The fact is, even after the dramatic declines of the Nasdaq, the dollar and overall business confidence over the past few years, most retirement plans are still precariously contingent on a combination of high equity returns, low inflation and an outperformance by U.S. assets.

Cash, in the pockets of individuals and investors alike, seems to be in historically short supply. So I'm padding my pockets with some liquidity these days. After all, there's no point in making money if you can't hold on to it.

Jonathan Hoenig is Managing Member at Capitalistpig Asset Management, a Chicago-based hedge fund.