Cash: An Embarrassment of Riches

Here's a Bloomberg screen showing the yield on 3-mo. T-bills since the beginning of last year. The world's favorite safe asset is now yielding close to ZERO (actually, 0.06%), and that yield has been declining for most of the year, despite the double-digit gains recorded by domestic and global stock markets, corporate bonds, industrial commodities, gold, and crude oil, and despite the strong fundamental backdrop of sharply lower swap spreads and implied volatility, and increased liquidity. With the Dow reaching 10,000 today, it is up 53% from its closing low last March, and the S&P 500 is up 61%.

In a post last December, I said:

It only makes sense to hold zero-interest cash if the prices of alternative investments continue to decline. If the economy doesn't continue to deteriorate significantly, then cash will prove to be a major embarrassment."

With the underlying fundamentals (e.g., swap spreads, agency spreads, implied volatility, liquidity) improving, the economy is not likely, in my view, to deteriorate enough to keep the prices of other assets declining. Thus, as time passes, investors will be compelled to trade in their cash (or increase their borrowings, since borrowing costs will be extraordinarily low) in exchange for riskier assets. And that in turn will set off a virtuous cycle to the upside which could be rather spectacular.

It took a few months for the rally to get started, and we had to suffer through the awful February-early March collapse, but we're clearly witnessing one of the most spectacular rallies in Wall Street history.

The Fed helped get this rally going by ensuring that there was no shortage of money (another favorite theme of mine). Even though people have been terrified of depression and deflation, and even though people continue to be awfully worried about a double-dip recession, a collapse of the commercial real estate market, another wave of residential defaults, the deleveraging of the household sector, and/or a potential Fed tightening, there remains the fact that the Fed is keeping short-term interest rate extraordinarily low.

To willingly hold cash that yields zero, you must be convinced that there is death and destruction awaiting at every turn. The market is climbing terrifying walls of worry, yet on the margin people are slowly being forced to reduce their money balances and increase their exposure to risk, and consumers are spending some of the cash they have hoarded, and it all adds up to a virtuous cycle that is giving us a V-shaped recovery. As long as the economy fails to deliver death and destruction, the market finds itself compelled to keep this virtuous cycle going.

The Fed should have started tightening awhile ago, but they are throwing caution to the wind in order to ensure a recovery. What the Fed wants, it can surely get. It may get more than it wants, in the form of asset price bubbles and higher inflation, but that remains to be seen. In the meantime, I don't see any signs that equities are overpriced (the Dow has only just returned to levels it first saw over 10 years ago) or that the market is overly confident (credit spreads are still very wide and implied volatility is still unusually high).

Comments

[Jasper M]

Historically, cash always appeared the least attractive when, in retrospect, it was the ideal choice. Late 20'sw come to mind. or, for that matter, the early 1720's.

2009 Oct 14 02:44 PM

[Robert Martorana]

Calafia Beach Pundit:
"To willingly hold cash that yields zero, you must be convinced that there is death and destruction awaiting at every turn."

Not true: Holding cash makes sense if duration risk is high. Investors who believe interest rates are headed up (due to either inflation or an economic recovery) don't want to lock in today's rates if tomorrow's are likely to be higher.
Rob

2009 Oct 14 03:11 PM

[thiazole]

Two examples over the past 300 years is a very far cry from "always".


On Oct 14 02:44 PM Jasper M wrote:

> Historically, cash always appeared the least attractive when, in
> retrospect, it was the ideal choice. Late 20'sw come to mind. or,
> for that matter, the early 1720's.

2009 Oct 14 03:51 PM

[PastTense]

"In the meantime, I don't see any signs that equities are overpriced"

Well then you need to start looking at corporate earnings: compare the PE ratio for the S&P 500 now vs other times.

2009 Oct 14 03:59 PM

[E Nuff Sed]

3 bearish comments and 1 bullish comment above. This straw poll suggest calafia's comment regarding the stock market climbing the wall of worry is apt.

2009 Oct 14 07:16 PM

[thetruthteller]

I don't see any signs that equities are overpriced (the Dow has only just returned to levels it first saw over 10 years ago)...

Relative value is a recipe for disaster. P/10E is at 19. This ratio (price divided by 10yr avg of earnings) developed by Benjamin Graham typically falls to 5-7 range after a major bust.

At least tell us how you determine that equities are fair value (earnings, interest rates, inflation, and other assumptions) instead of throwing out such a meaningless and misleading statement.

2009 Oct 14 09:23 PM

[altaman]

This market upturn is just another bubble blown by the fed and Obama's captive banks trading for their own accounts using taxpayer money. When it pops, and it will, the carnage will be bad. The messes underlying the financial meltdown have not been corrected and the chickens will come home to roost with a vengence.

2009 Oct 14 09:54 PM

[The Geoffster]

I think you are right about the bubble and the trading desks but would add that any trading losses will also be covered by the taxpayers. This explains the breakout in gold as an alternative currency.


On Oct 14 09:54 PM altaman wrote:

> This market upturn is just another bubble blown by the fed and Obama's
> captive banks trading for their own accounts using taxpayer money.
> When it pops, and it will, the carnage will be bad. The messes
> underlying the financial meltdown have not been corrected and the
> chickens will come home to roost with a vengence.

2009 Oct 14 10:34 PM

[thiazole]

The S&P isn't a corporation. Why not look at individual companies in the S&P?


On Oct 14 03:59 PM PastTense wrote:

> "In the meantime, I don't see any signs that equities are overpriced"
>
>
> Well then you need to start looking at corporate earnings: compare
> the PE ratio for the S&P 500 now vs other times.

2009 Oct 15 10:08 AM

[phdinsuntanning]

as usual your optimism blinds your beach views. This liquidity for risk takers devaluation is easy profits for banks and for us beach boys baby boomers. A vampire way to recapitalize the broken financial system at the expense of the real economy. You like Brazil, Argentina, ok, study what they did in the 1980s, because this is what OECD is doing now: the lost decade. 1929 also was V shaped, if you look 5 years time series, this time is becoming more like the 1970s after the Vietnam blood and the arab oil revenge. Markets are not overpriced measured in real or even Euro, or troy oz., they are doing 1000s % in cruzados or argentina pesos of the 1980s, this is the virtuous cycle you are promoting. Just tell me one government that escaped hyperinflation voluntarily:
ok, Paul Volker 1983, but he is old to repeat the trick again and you need Pinochet to do the right thing and take a 15 % GDP healthy contraction selling your assets Rudy Dornbush overshooting style and getting out of the current mess in great style. Guts anyone? Naaa, you will be bleeding Japanese style for years as ChinAmerica Republican dream starts vanishing and sovereign Chinese CDS starts balloon fly in the sunset pink sky.

2009 Oct 17 05:10 AM

[john s. gordon]

in 1930 after the federal reserve shrank the money supply cash was indeed king, if you had any.
joseph kennedy sr. in the summer of 1929 converted all his 'investments' (many people including banks (who should have known better) were using 9/1 leverage) to cash. today goldman sachs & the other manipulators use 40/1 leverage & it's all perfectly legal.
in the 1930's the rockefeller interests went all over the country buying up distressed assets @ 3 cents on the dollar.
> jack

2009 Oct 19 04:37 PM