Prepare for a crash

"When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." This quote, given to the FT in July 2007 by Citigroup's then-chief executive Chuck Prince, should be nailed to the wall of every private investor. No other piece of Wall Street wisdom comes close to Prince's perfect encapsulation of how the financial industry works during a bubble.

One thing that people get wrong about bubbles all the time is that no one sees them coming. As Prince's quote shows, this isn't true. You need only read a newspaper today to realise that plenty of financial professionals feel wary of markets right now every other investment section contains someone quoting the Shiller price/earnings ratio and marvelling at the latest "top of the market" indicator (such as the launch of a financial instrument dedicated solely to trading the biggest tech stocks using borrowed money). In fact, according to the latest fund manager sentiment survey from Bank of America Merrill Lynch, more fund managers than ever before believe the stockmarket is overvalued and that they are taking more risk than usual by remaining invested. And yet, they're still dancing. Cash levels are falling fast at 4.4%, they're below the ten-year average of 4.5% and well down from highs of near-6% last year.

The problem with bubbles is that timing your exit is tricky. And the brutal calculus is that, if you are an investment professional, it is far better to get caught up in a crash with 95% of your peers, than to pull out early and miss the juiciest bits of the "melt-up" as a result. After all, if you pull out too early, it's your job that's at risk. If you hang on for the bust, it's merely your clients' savings.

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As a private investor you are under no pressure to be as relaxed about these things. So should you prepare for a crash? There are some worrying signs. Over and above the capitulation of the fund-management industry, we're also seeing stress in the junk-bond market. None of this means a 1987-style panic or a 2008-style crisis is imminent. But it's probably not a bad idea to take stock of your asset allocation, make sure you are happy with it, and if you're not, rebalance your portfolio and perhaps also raise the levels of cash you hold.

The nice thing about cash is that it gives you options if prices fall, you have a cushion to prevent panic and also money ready to invest when stocks get cheaper. Economist Andrew Smithers points out that a 30% holding in cash becomes more like 50% if equities fall in half, as John Authers notes in the FT. That sounds like a sensible compromise to us.