Wednesday, February 8, 2012

The cash conundrum revisited

I began getting very bullish back in December 2008, having observed numerous signs of improvement, most notably declining swap spreads and the Fed's aggressive expansion of the monetary base. In one post around mid-December, "The coming cash conundrum and the return of the carry trade," I wondered how long it would take people to realize that holding lots of cash (a very popular idea at the time, given how fearful people were that the end of the world as we know it was approaching) would be embarrassing. After all, holding cash that pays zero interest only makes sense if the prices of riskier assets decline; if they just hold steady, riskier assets beat cash due to their higher intrinsic yield. If, as I thought, a recovery was in sight, then the deleveraging that characterized 2008 would soon reverse and releveraging would return to fashion. I was a little early calling the low in the stock market, and the return to releveraging took a lot longer than I thought (see my post yesterday on this subject), but with the benefit of hindsight, dumping cash at the end of 2008 and buying stocks was a very profitable strategy: the total return on the S&P 500 since late December has been about 65%, vs. almost nothing for cash.

So, more than three years later I ask the question again, amazed that it still needs asking: how much longer will the public be content to sit on a mountain of cash? Especially now that the economy has been growing for the past two and a half years, swap spreads are back to normal, corporate default rates have plunged, corporate profits are at record highs, residential construction is beginning to turn up, job growth has picked up, and cash still yields zero? Can the economy's prospects be so dismal that it still makes sense to hold zero-yielding cash in the belief that most other assets will decline in price?


According to ISI, domestic equity mutual funds have suffered net outflows of some $355 billion since Sep. '08, with $155 billion of that occurring since last April, and $6 billion so far this year. While investors have shunned the equity market, the demand for safe-haven cash has been intense. Since September '08, households have socked away just over $2 trillion in bank savings deposits that pay next to nothing (see chart above). Moreover, the banking system has been content to sit on $1.5 trillion of excess bank reserves (see chart below) that pay only 0.25% per year (i.e., the proceeds from the sale of MBS and Treasury notes and bonds to the Fed). Apparently, there is still lots of fear out there, and there seems to be no shortage of gloom and doom predictions.


But turning a blind eye to the alternatives to cash requires a deep conviction that the future is going to be miserable. Consider: the average yield on investment grade corporate bonds is over 4%; REITS are yielding 4%; the average yield on BAA corporate bonds is over 5%; the average yield on junk bonds is over 7%; and the earnings yield on the S&P 500 is over 7%.

Ignoring those very attractive yields in favor of zero-yielding cash also means paying no attention to the Fed's very explicit desire to convince the public that holding cash makes no sense at all, and it's only a small logical leap to the corollary that borrowing money makes lots of sense. It rarely pays to fight the Fed.

9 comments:

Donny Baseball said...

As Mike Holland said, "the idiots who run the world" are still active and dangerous. The world is very unsettled and we have, in the heart of the Western world, governments who would expropriate assets baldly if they felt they could get away with it. Cash is at least mobile and can stay one step ahead of the tax man/law man.

Benjamin said...

A terrific wrap-up by Scott Grannis, and Grannis has been mostly right in the past--as evidenced by the 65 percent run-up in the S&P 500 since 2008, as noted.

Why all the fear? Well, there was the wide-spread bank collapses of 2008, and even on-the-street televised bank runs at Indy Mac. GM declared Chapter 11. Two unfinished open-ended wars in Asia, costing trillions of dollars, mounting welfare and entitlement outlays.

Add to that widespread scare-mongering on talk radio, a rising Gold Nut parade, an obstructionist GOP and a Dem President who seems to dislike business. Ugly-time, and even the threat of deflation.

But when this dam bursts, it will be on the upside. If the S&P can rally for just a couple months, look for funds to start going back into mutual funds. Property is already rallying in many markets.

The Fed need to get aggressive, and do some serious QE and announce it is shifting emphasis to growth.


The battle now is for prosperity. If the inflation hawks suffocate the economy, look for more of the same, possibly for decades, ala Japan. If Bernanke can see his way to a better, more expansionary monetary policy, look for a huge secular rally.

William said...

After the severe Bear Market of 1972 - 1974, net equity withdrawals from stock mutual funds continued until the mid-1980's.

Like today this was partly because the DOW Industrials first hit 1000 in 1969 and again in 1972. Then the DOW 30, like a yo-yo, went up and down between the 600s and 900s until the decisive break above 1000 in 1982. Market participants have very long memories.

The major difference with today is that in the late 1970s and 1980s, money market funds came into existence and paid very high yields as FED Chairman Paul Volcker fought high inflation.

Benjamin said...

William-

You are right---and there is no place for money today. No yields.

Savers may have to get used to very low yields for a long time,

More aggressive investors may do much better.

Public Library said...

The S/P hasn't budged for 12-13 years except for wild gyrations down 40% or more.

We now have a slew of boomers creeping towards the event horizon. The global balance sheet has mushroomed with debt (forget private debt at this point).

Where is the conundrum?

Hans said...

Bank Bernank has kilt cash and soon federal debt will do what has not been done before...

Good points by Baseball and Library...

The points made by Mr Grannis are indeed very valid, but this environment is much, much different than the one thirty years ago...

Today's investment entail by far a higher degree of risk and thus capital must be very nimble...

Did anyone hear today's warning of a sudden financial event by the Federal Chairman?

schwabber said...

The Fed is artificially inflating all asset prices, just like they did to housing prices a few years ago. People saw how it turned out if you chased the rising housing prices. Not to mention, we know the Fed tips off Wall Street of their actions before they announce them publicly, under the rubric of getting information about the economy. Wall Street has front run everyone and will bail out first. Fool us once shame on you, fool us twice . . .

It is perfectly rational to sit in cash, unfortunately for savers, I don't think the Fed will ever let market forces work. Moral hazard be damned.

Apparently the Fed thinks forcing boomers to put their life savings in risky assets just before (or in) retirement is a good idea. At the same time they are advocating structural changes (deficit cutting) that will obviously create a headwind for the economy. There are no free lunches. This will all end very badly.

John said...

Why stick with cash? Simple. Cash is insured. Here is a disclaimer note Barry Ritholz found and posted at the Big Picture under "best disclaimer"

"The future is unknowable. We have good intentions but all of our projections and estimates will be wrong, and could be materially wrong. Wildcat exploration is expensive, speculative and potentially dangerous. An offshore spill or explosion would be enormously expensive. We have insurance but it may not be enough. You could lose your entire investment. Don’t be lazy – read our 10-Q’s, 10-K’s and press releases, and if you lose money – please no tears.

“Don’t forget about risk-free T-bills in your portfolio…After inflation and taxes you’ll likely only lose 5-10% of your investment.”

- Contango V.P. Investor Relations

Hans said...

This massive pool of cash maybe be viewed by the Central government as it's Argentina moment...