THE CASH CONUNDRUM
If you’re a money manager sitting on a large cash position and you missed out on the 50% rally from the March bottom you have quite a dilemma on your hands. With the S&P 500 up 11% year to date the majority of money managers are starting to feel the pressures that come with the relative return demands of investors.
As John Hussman has thoroughly explained (and TV commentators often ignore), the famed “cash on the sidelines” has little to do with future market price. The psychology, however, with regards to cash on the sidelines makes all the difference in the world. If you’re a money manager who sought the safety of cash last year and now feels the pressure to reach for risk and returns you are more willing to bid prices up. You’re more desperate than the seller on the other side of the trade. Like the fear that drove the market down last fall we are now seeing the inverse occur as money managers chase performance. This is an overly simplified example of how psychology drives price, but you get the point. The latest JP Morgan strategy update succinctly summarizes:
The flight from cash is steadily overtaking the economic recovery story as the main driver of higher asset prices. Even people who are not believers in a robust economic rebound still feel forced to try and get some sort of positive return on assets other than cash.
This flow from cash is seen by some as just a liquidity driven reflation of asset prices that has nothing to do with fundamentals and is therefore suspect. We do not agree. The flight from cash is not by itself a rise in leverage, which is where true risk comes from. Instead, the flow from cash is what economists call the transmission mechanism. Central banks cut rates to prevent economic agents from piling into cash and cutting spending to the bone all at the same time. This policy is working now, as global consumption is starting to rise and the return to risky assets is allowing companies and other borrowers to obtain necessary funding again. The resulting reflation of asset prices will be ultimately damaging only if central banks keep rates low for too long. We remain quite far from this risk.
In terms of value, cash as a long-term holding is an incredibly destructive asset to hold in ones portfolio. This realization forces money managers to put money to work in any number of assets. As reflation becomes the overriding theme and deflationary thoughts subside the logical beneficiary of asset allocation is equities:
Many equity bears argue that stocks have become expensive, frequently stating that multiples have risen to above historic averages. It could similarly be said that government bonds are expensive, as yields are below historic means. We do not disagree with these yield observations, but disagree with the implications for value. Simply put,
historic comparisons on yields have little relevance, as investors cannot buy assets at past prices. You can only buy what is available today. Hence, the relevant comparison of an asset’s value is not against its own history, which cannot be bought, but against other assets available for sale today. By that standard, both equities and bonds are cheap and attractive, in our view.
Consider the US risk-return trade-off line above. It shows internal rates of return for major asset classes –– cash, Treasuries, high grade, high-yield, external debt, and equities. For credit, we deduct from the yield the expected medium-term losses resulting from default. Equities IRRs are earnings yields (E/P) based on either trend operating or reported earnings, plus expected long-term inflation. Risk is annual return volatility over the past 25 years. Using 5- year volatility makes little difference.
JP Morgan argues that stocks are an especially good value when compared to bonds currently:
The important anomaly versus history is the steepness of the risk-return trade-off line. At 0.6, this Sharpe ratio is twice its historic mean. That is, investors are offered twice the historic return to increasing risk. The first foray out of cash this year along this risk return trade-off has been into bonds, and especially into credit. Credit started rallying early this year, before there was any sign of an end to recession. This flow into credit remains strong, but falling yields should slow this flow and redirect it into equities.
The conclusion? The loser in the current market environment is large cash holdings:
Overall, both the equity and bond asset class are cheap versus cash. It is cash that is the expensive asset class. King cash is losing its crown.
Source: JPM
The problem with all these calls of analysts & economists is that their track records are pretty pathetic. Not only that, their self-interest motives are in question. Taking into consideration of jobless rate, foreclosures that are higher than last year when the crisis started I am skeptical about this call of higher market. Cash maybe dethroned right now but I believe that the king will be back soon enough. Right now I am happy with cash at the end of the day.
TPC, would you happen to have the numbers on the flow of mutual funds money and money market?
Looking through the rear view mirror, one might agree with this thesis.
However, assuming that what Prechter is saying is true, regarding future strength in the US dollar, maybe holding cash is not such a bad idea:
http://www.youtube.com/watch?v=jQ_4Km90bkk
I don’t follow this stuff as closely as you, TPC, but from what I understand the ‘average mutual fund manager’ is far, far, ahead of his or her benchmark this year. I’m sure there are a few people who have held far too much cash, but is that really any different than any other snapshot in time? It’s all really just another reason to never hand over your money to someone else to manage. They make decisions based on their paycheck for the current calendar year, and not your net worth. And, I agree with sentiment of Henry’s comment above. It’s 2009 and the S&P 500 is at 1,000. Not one of these chumps had this outcome in their forecasts from five years ago. Their job at their bank or brokerage is to drive transactions. They are to put out research pieces that drive customers, both institutional and retail, to act. They don’t even necessarily care what the customer does, as long as they do something.
Aside from their comment on the steepness of the return-risk line (interesting historical pt; but, have no idea if it’s true), everything else is orthodox. The question is whether forward looking corporate profits on that chart is actually going to happen over the next 5-10 years; this analysis doesn’t say anything about that.
These guys were too bullish on the way down. Their tune hasn’t changed a bit on the way up.
It’s an interesting perspective. Obviously, I don’t agree with it entirely or I’d be more heavily invested in stocks as opposed to a large cash weighting, but readers should always consider both sides of the trade….
TPC,
Why are you so heavily in cash at the moment if cash is trash?
Rob,
This is JPM’s current opinion, not necessarily mine. I am more focused on the realization that many money managers have to reach for returns now.
As I’ve described in “Why You Trade Like a Loser”:
“As I said earlier, when everyone is thinking the same, someone isn’t thinking. Learn to go against the crowd. And when the boat feels like it’s tipping to one side, jump off or consider moving to the other side. And never let anyone tell you cash isn’t a position. If you feel uncertain or uncomfortable pull your portfolio out of the game. Like blackjack, there is no rule that says you have to play every hand. For more sophisticated investors cash can also serve as an alternative asset class via currency markets.”
Cash and currencies are probably my favorite position. It just so happens that cash positions are currently a driver of sentiment. I don’t think that makes cash a terrible position. But I recognize it as a potential catalyst for a bullish position.
Just providing some alternative perspective….
Also see here Rob:
http://pragcap.com/using-cash-to-boost-your-portfolio
I should add that everything I provide here is not necessarily my opinion. I am trying to provide readers with a multitude of outlooks and perspectives so that they can come to their own conclusions about the market. I often nudge readers in one direction, but don’t assume that every piece is my opinion or is backed by a market position.
Only losers are Americans and people holding US denominated Assets.
Everyone else wins.
I don’t like the relativistic argument against historic comparisons within asset classes. If everything looks expensive today I’m not buying. That said, I’ve been scaling into cash since May, and maybe I’ll continue to regret that. It doesn’t look brilliant at the moment, but it didn’t look brilliant in mid-2007 either.
It does reinforce the axiom, “Don’t fight the Fed.”
Cash has lost it’s crown?
Wonderful – now I feel much better about being in cash 90% (selling options and collecting dividends in my few longs).
These geniuses are so consistently wrong that all one need do is fade them to do well in investing. And if equity markets keep running higher, no problem, I’ll feel much more comfortable shorting it at that level than committing too much to the long side at this point. The time to be long was in March (which I was). Yes, I closed most of my longs way too early (@ SPX 900). That’s just fine with me. Not a pig.
I remember hearing the “Cash is Trash” argument last spring/summer as well (not necessarily from JPM). How well did that work out?
Also, fund managers seem to be very heavily weighted in equities right now and low on cash according to Mother Merrill.
http://www.ritholtz.com/blog/2009/08/merrill-lynch-global-fund-manager-survey/
Cash in the form of money market or currencies is likely my absolute favorite risk management tool. The people that trash cash are likely the same people that don’t truly understand risk management.
“When in doubt, get out” has saved my skin on more than one occasion. Most notably, sitting out the entire 50% decline last year. Trashing cash is like saying that you should play every hand at the blackjack table. No thanks. That’s exactly what the casino wants you to do.
TPC, by cash I presume you mean USD. What are the other currency positions that you currently favor / short?
When I look at the DX chart and hear all the negative comments about the Greenback — whether from Asia, Pimco, or Buffett, I am coming to the opinion that the decline in the dollar is coming to an end at least for the near term.
Why?
When it comes to demand in a debt ridden society, Dollars are what everybody wants at the moment and future. Take the credit card companies, these pigs feed at the trough of low interest rates and gorged themselves to no end, but now they need DOLLARS to cover their loses and therefore are jacking up card rates because they need DOLLARS to cover their loses.
I don’t think they are doing this in anticipation of hyperinflation yet, they are making money hand over fist at a ZIRP rate.
They want your dollars now and are trying to force as many hands as possible to pay up BEFORE they jack the rates. Or before Ben jacks the rates.
Either way, my point is that Dollars are in demand more than stuff from China or RE, or any other asset and soon I believe people will realize that DEFLATION is actually better than hyperinflation.
I say the DX is going to rise in the near term.
The only concern I have to this is Ben and his desire to be reappointed to the Chairman’s position.
Maybe Ben will surprise us and not continue QE for the moment. I hope so.
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