yusnizam/iStock via Getty Images

yusnizam/iStock via Getty Images

Now is a challenging time for investors. Stock valuation is at a record high, bond yields are at a record low, and several crucial macroeconomic uncertainties are unfolding. As mentioned in our newly launched market service, we feel urged to remind investors that at times like this, it is especially important to stay disciplined and stay with simple and proven methods that you truly understand.

And a key to stay disciplined is to ALWAYS delineate short-term survival/withdrawal from long-term growth. Sadly, we’ve seen too many people around us make the tragic wrong moves, especially at our current extreme market junctures. Now specific to the SPDR S&P 500 Trust ETF (NYSEARCA:SPY ) and its role in our survival/withdrawal portfolio, we ourselves have been seeing and publishing warning signs since last November. For example:

Those were clear signals for us. And we sold some equity and bond to increase our cash allocation. Shortly after this allocation change, both the stock and bond market went through a sizable correction as you can see next. As of this writing, SPY fell by about 7% (and the NASDAQ index fell more if you hold those funds). At the same time, the 10-year Treasury bond fell by more than 5%.

Looking forward, we see now is a good time to deploy some of the cash we reserved (and hopefully you did too) when both the equity and bond market peaked. More specifically, the remainder of this article will show:

Source: author and Yahoo finance

Source: author and Yahoo finance

The underlying idea here is quite simple and intuitive. The summation of stock yield and bond yield provides a measure of the opportunity cost of holding cash. If the summation is high, it means the opportunity cost of holding cash is high. Because I could earn a high yield if the cash is invested either from bond or stock. And I will hold less cash in this case. Vice versa, if the summation is low, it means the opportunity cost of holding cash is low. I have no good place to invest the cash because bond yield and stock market yield are low.

With this overall concept, you can see that the summation has been in the range between about 2.5% and 5% in the past decade. The 5% summation level was reached 3 times, all during times when either stock, or bond, or both are in attractive valuation. And these are the times that I would be willing to take more risks and significantly reduce my cash position to invest in the stock, bond, or both. On the other hand, when the summation becomes lower, I will begin to increase my cash holding. And when it is low enough (like it is now), I will keep increasing my cash position until I reach a ceiling around or even above the 6 months of living expenses as aforementioned. Under this context, you can clearly see the warning signs I pointed out during Nov and Dec of 2021.

Lastly, note that the EI that we actually use is a bit more complicated than this (although the data in the chart illustrates the essence of the idea). In practice, the dividend yield from the stock market does not always reflect business fundamentals and can be distorted by things like:

Thus we have to develop a proprietary algorithm to adjust for these factors and correct the distortion. But again, the simple summation of yields provides a good approximation already and illustrates the essence of the EI idea.

In short, we did what we wrote (and we always do).

Since the opportunity cost of holding has become so low during Nov to Dec 2021 (again because the EI was near record low during that time), we sold both bonds and equity in our accounts during our Nov and Dec 2021 account maintenance and raised our cash holding by ~3% to 13%. And our maximum cash allocation is designed following this guideline: the cash holding is such that the cash, when combined with the intermediate bonds and the dividends generated by this portfolio, should be able to cover about 6 months of our living expenses.

Then during our mid-Jan 2022 maintenance, we deployed the cash and bought back the bond and equity at a lower price.

A cash allocation near 13% is close to our maximum allocation under this guideline, and we felt no fear at all for missing out should the bond and/stock make a new high - our motto is that we only need to become rich once in this lifetime. We really urge our readers to be more on the cautious side under these market conditions and do not pursue growth UNLESS/UNTIL you have put aside enough funds in your survival portfolio.

I do not rebalance my portfolio that often to minimize turnover and efforts (and tax consequences for my taxable accounts). I rebalance my portfolio monthly in the middle of every month. Also, I only rebalance when the change is large enough – i.e., the change in the yield spread needs beyond some threshold to trigger a rebalance. So that is the reason why you do not see that many changes (or large changes) historically, but you see:

The next few charts show the actual results of our survival/withdrawal account since we first wrote about it on SA back in May 2021, and also the backtest results over a longer period of time (we have finalized the model and started executing it ourselves since about 2010). The backtest runs back to 1994 because that’s when SPY was launched. A couple of key takeaways:

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

The SPY fund is a cornerstone for many investors like ourselves. With the fund’s valuation near a history peak, not only its own history but the entire history of the stock market, we feel urged to remind ourselves and other investors that:

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As you can tell, our core style is to provide actionable and unambiguous ideas from our independent research. If your share this investment style, check out Envision Early Retirement. It provides at least 2x in-depth articles per week on such ideas.

We have proven and perfected our methods with our own money and efforts for the past 15 years. For example, our aggressive growth portfolio has helped ourselves and many around us to maximize return with minimal drawdowns.

Lastly, do not hesitate to take advantage of the free-trials - they are absolutely 100% Risk-Free.

This article was written by

** Disclosure** I am associated with Envision Research

I am an economist by training, with a focus on financial economics. After I completed my PhD, I have been professionally working as a quantitative modeler, with a focus on the mortgage market, commercial market, and the banking industry for more than a decade. And at the same time, I have been managing several investment accounts for my family for the past 15 years, going through two market crashes and an incredible long bull market in between. 

My writing interests are mostly asset allocation and ETFs, particularly those related to the overall market, bonds, banking and financial sectors, and housing markets. I have been a long time SA reader, and am excited to become a more active participator in this wonderful community! 

Disclosure: I/we have a beneficial long position in the shares of SPY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.