Where Will New Money Flow?

There is reportedly $4 trillion parked in U.S money market funds and other cash equivalents getting a return of approximately zero. That’s a large cash allocation. Breaking even seemed great a few months ago when most investors were being crushed by falling equity prices. But now pessimism is waning and the last couple of months’ returns have been record-setting. So cash is now starting to feel under-appreciated, pun intended.

One principle of investing always holds true: funds must land somewhere. So cash funds will either be re-invested where they are - or they must move into another asset class. On the surface, the vastness of the cash pool and the potential for movement which it represents seems bullish for stocks. But there are alternative asset classes into which it could be channeled instead of stocks. Let’s look at the relative attractiveness of owning equities vs. owning other asset classes. The major basic asset classes (all of which have sub-categories) are:

• Cash
• Bonds
• Stocks
• Private equity/hedge funds
• Real estate
• Commodities
• Gold/silver

Cash

Today’s cash hoard may stay put for longer than one might expect given the shock of the past nine months. Cash could seem especially attractive once a retrenchment in stocks starts. But at some point greed will decisively replace fear and then more capital will strive for an above-zero return. So my thesis is that money will move out of cash as the economy changes from recession to growth, greed begins to replace fear, and as inflation becomes more evident.

Bonds

The attractiveness of bonds as an investment alternative depends largely on the direction of interest rates. From 1982 to the present we’ve experienced an unprecedented decline in interest rates. Over that period most bonds have performed well compared with stocks as of 12/31/08 . But if, as I believe, interest rates are starting a long term up-trend based on increasing inflationary expectations, then the attractiveness of bonds may be reduced.

For investors concerned about total return on an annual (or more frequent) basis upward trending interest rates will cause bonds to provide negative total returns. Therefore, to the extent that the $4 trillion money market hoard is held by investors who are sensitive to annual or quarterly returns, bonds will not prove to be a popular.

But if one holds bonds to maturity and cares not about intermediate portfolio valuation, then bonds can be a core portfolio holding and they actually become more attractive as interest rates go higher. If we do see rising yields, I suspect many institutional investors like universities and pension funds, having been burned by both stocks and hedge funds, will allocate more of their portfolios to bonds, thus returning to a more traditional investment posture and tending to pull money away from stocks as well as cash.

Some economists believe the recession still has the potential to turn into a depression - or at least into an “L” shaped recovery that will require many years, perhaps a decade, before robust growth returns to the global economy. Such analysts think deflation is still a more likely near term outcome than inflation. If they are correct then high quality bonds are a good buy for any investor. Those investors who agree with the deflationary outlook prediction will move money into bonds - but I doubt many investors actually do have the courage of that conviction.

Incidentally, I’ll be so bold as to say that I expect a less extreme outcome than simply inflation or deflation. I think we’ll see a generally rising trend of long term interest rates but that it will be in the form of an upwardly sloping sine curve. For example, any significant rise in rates may produce Federal Reserve actions to counter that move. On the other hand, signs of rising rates could cause home buyers to more rapidly make purchases in order to lock in low rates before they go higher. That, in turn, could stabilize housing prices and thus hasten economic recovery - which could eventually tend to push rates higher.

In other words there is likely to be an Hagelian push-pull on rates. One trend causes a counter trend. Unexpected events occur and expected events sometimes have unexpected consequences. So predicting interest rates may be the original fool’s errand. Rates move up and down in the short term. But on a longer term basis it seems reasonable to expect an upward direction from here given their very low absolute level and the heroic financial actions recently taken by governments. Therefore I am short bonds via a Proshares short bond ETF, symbol TBT.

One sub-category of bonds may do particularly well going forward - convertible bonds. Converts can provide both a higher yield than dividends and the potential of rising prices from the convertibility feature. There are convertible bond ETFs that investors may want to consider. I would expect converts to get a decent share of the funds moving out of cash.

Stocks

In March stocks - especially financial stocks - were priced for disaster. Since then, as disaster seems to have been averted, many stocks have doubled or more in price. Now the overwhelming value that stocks represented a few months ago is gone. Yet many issues are still depressed compared with their pre-crash prices. For example, a shipping company that I favor, TBS International (TBSI) is selling for about 12% of its pre-recession high - which price was only an 11 multiple on its peak earnings.

If stocks are arguably still cheap (assuming recovery is around the corner), then for as long as greed is growing and fear declining I would expect that stocks will continue to attract some of the $4 trillion hoard of cash currently on the sidelines. My sense is that a new bullish market is developing.

I say “bullish market” rather than “bull market” because I doubt it will move powerfully up. I suspect stock prices will top out well before they return to their August, 2008 levels. One reason is that the economy is unlikely to recover to the levels that we saw in recent years. That level of GDP was based on mortgage, housing and finance bubbles that will not soon recur. Stocks will also be hampered by the likely rise in long term interest rates and by the likely rise in commodity prices that will reinforce fears of incipient inflation.

At some point, therefore, I would expect the current bullish move in stocks to peter out and I would expect that a period of range-bound trading will occur, much like the period of 1976 - 1982. An essentially trendless market becomes a “stock pickers market.” You make money by being in the right special situation or economic sector, not just by being invested in “stocks.” For example, if oil prices rise over the next two or three years as I expect, certain energy stocks will be advantaged. Another relatively attractive group will be stocks with high dividend yields and the potential to increase them.

For the moment I am riding this bull. I will admit to being nervous about how long it will continue but I think some surprisingly positive developments could ensue over then next 12 - 24 months (see “real estate” below). The time to really pull back on equities will be when a more general sense of bullishness prevails. Right now it seems to me that stocks have risen without very broad participation. There may have been a lot of short covering. But the general emotional state of the market is still more skeptical than bullish. That’s a far distance from real greed, which is when you want to get seriously conservative in regard to stocks.

Private Equity and Hedge Funds

The last ten years have been the hey-day for private equity and hedge funds, especially “funds of funds.” I suspect that era is gone for a while. Between revulsion at high fees, fear of lock-ups, fear of another Bernie Madoff, and poor returns on leveraged corporate and real estate deals (and more quarters of such poor returns to come), I suspect that institutional money will continue to flow out of this area for a while. Pension funds and other long term investors may develop a desire for predictability of return and safety of principle. Thus, they will increasingly shift money into bonds on a hold-to-maturity basis and they may find convertible bonds increasingly attractive.

Real Estate

Speculators in real estate, both individual and institutional, have been badly burned. It’s doubtful that speculative (investment) money will quickly flow back into real estate for several years at least. If interest rates begin to rise, as I suspect they will, conventional wisdom says real estate prices will suffer. But I think rising rates could cause legitimate home buyers (not speculators) to hasten purchases in order to lock in rates before they go even higher. That could help stabilize home prices and therefore the banking system and could be bullish for stocks. It will not cause housing prices to rise rapidly, only to stabilize.

Commodities

China. That may be all an investor needs to know about commodities. China will be the growth engine of the global economy going forward. It has the cash to finance growth. It has the long range plan to achieve growth. And most important, it must have growth if it is to create the jobs needed to keep its population from demanding political change.

China was growing 11% a year, a phenomenal rate that seems unsustainable. That rate of growth is now down substantially - well below what the government wants to see. So the government has adopted a huge stimulus program and implemented it more effectively than the U.S. by issuing purchase credits to consumers to directly stimulate them to buy.

The Chinese government wants China to grow the same way the U.S. did after the Civil War - by creating a huge consumer economy and spreading out development across their broad geographic territory. They are stimulating particular industries - such as automobiles - to leapfrog old technologies and give Chinese consumers as good an option for personal transportation as exists anywhere. Then they offer consumers rewards for buying the more efficient cars. They are also building state-of-the-art electrical generating plants including coal fired plants with excellent carbon-reduction characteristics. In sum they are both thinking long term and being very practical in stimulating consumption.

China has been stockpiling commodities and it continues to do so. Gold, oil, copper, rare earth elements - and who knows what else. China is not doing this for its health of for lack of other things to do. As the new global engine of growth China is the paradigm commodity “insider.” That is, they’ve seen the numbers on China’s huge component of future global commodity demand - because they wrote the numbers.

So I think we know the answer to the question of commodity prices. As soon as the world starts growing again it’s a fairly safe bet that commodity prices will be rising again. Which ones? My guess is: all of them. I own equities and futures contracts relating to oil, copper, rare earth elements and, in a smaller way, gold. I think that fundamental and speculative demand - and a continually falling U.S. dollar - will combine to drive commodity prices to much higher levels.

Precious Metals

Gold and silver are a sub-set of commodities but are often thought of as an asset class in themselves. They are considered an inflation hedge. Many market commentators are now convinced that inflation will be our economic fate as a result of OECD countries pouring massive funds into their banking systems and deficit spending in the face of the recession. I’m not sufficiently convinced that inflation is our near term fate to want to own a lot of gold now. But since I do own a lot of oil, I don’t worry about not owning gold. It seems very unlikely to me that if gold appreciates oil would not do so as well. So I’m covered on inflation. On the other hand, it’s quite conceivable that oil could appreciate based on supply/demand dynamics absent any great inflation while gold might not appreciate so much in that case.

But - you might ask - didn’t I just write that the Chinese are stockpiling gold and that the Chinese are very canny guys? True. But my take on Chinese gold purchases is that China is starting to plan for the day when the yuan will be an international reserve currency. That must happen when China becomes the largest economy on the planet, which probably won’t be more than 25 years from now. I think the Chinese see themselves as the global superpower of the future. One thing that defines a global superpower - and a nation whose currency is held by others as reserves - is that it owns a lot of gold. So, since the Chinese are now floating in dollars which have a reasonable chance of losing value in future years, why not trade some of them now for some of the gold that will be needed down the road? That’s why they’re buying gold.

Bottom Line

Add this all up and it says that the current unsustainably high concentration of funds in cash will be resolved by a movement over time into stocks, bonds, and industrial commodities. And when you think of it, doesn’t that simply define a movement from economic stagnation to economic dynamism? After all, what do you need to support economic growth if not corporate finance (stocks and bonds) and industrial commodities?

So, will stocks go straight up from here? No, duh. Nearly every analyst is saying the market has come too far too fast and needs a pullback. Great, let’s have one. But over the next few years it’s a pretty good bet that the direction of stocks will be up. I think this is a decent time to be an equity investor. It may be a great time to be a commodities investor.

Comments

[RiskReturnO...:]

Long convertibles bonds, short treasuries to hedge for interest rate / inflation risk, short little of common stocks to hedge for prolonged economic recession.

May 13 12:00 PM

[Larry House:]

Useful ideas. Thanks, Jim. There are always risks along with opportunities.

May 13 01:24 PM

[Yoon Kim:]

Money will flow straight into the pockets of Goldman Sachs directors and executives. Our only hope is that hyperinflation would render their golden parachutes worthless versus real wealth that they wish they had received real golden parachutes instead of one full of TARP dollars.

May 13 02:52 PM

[Mistrofan:]

Cetin - you might be right. I was thinking at this scenario. In a world of high interest rates (for consumer and companies), with an increasing persoanal saving rate (meaning less real estate and less discretionary) and with the end of playing the small-cap game (based on the big numbers rule) and, only if, we consider NO increase in Commodities prices (due to a very slow recovery/expansion), then what is left is exactly what you say: multi-nationals with strong balance sheets and strong brand names.

But this is the scenario for 0-2% growth of World GDP in the next 5 years. Will that be the case? (due to a continous srinking of banks balance sheets and increased interest rates). Remains to be seen...


On May 13 01:44 PM Cetin Hakimoglu wrote:

> Money will flow out of the dollar into the Euro. Money will flow
> into large cap multinational stocks.

May 13 07:21 PM

[Jimbo:]

An excellent and credible overview

May 14 02:26 PM

[TinyTim:]

Good stuff.
Uncommon common sense.

May 14 05:44 PM