The purpose of this piece is to reconcile two contrasting viewpoints on how the amount of cash in our economy impacts future stock prices:

A. Sidelined Cash View: An example of the view that cash held in investor accounts matters was Alexander Green's commentary this past week:

In February . . . the decline in stocks was just about over [because] . . . [t]here was more money available to buy shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds was equal to 74% of the market value of U.S. companies, the highest ratio since 1990, according to the Federal Reserve. . . . [T]here is still over $8 trillion on the sidelines earning next to nothing in short-term deposits. . . . Expect to see cash coming off the sidelines to accumulate shares of the largest, most liquid firms around the globe.

During the past half year, the concerns of the Fed have shifted from worry about commodity-driven inflation (recall $147 oil in July) to its polar opposite--fear about the onset of deflation (coinciding with oil falling below $40 today). With short-term interest rates now lower than the targeted 1% rate, traditional monetary policy measures have become less potent and the U.S. economy is more susceptible to descending into a "liquidity trap."

As mentioned by Ben Bernanke in a 2002 speech, one way out of such a predicament is a "helicopter drop"--effectively dropping money from helicopters to consumers and businesses below in order to thwart deflation, stimulate spending and prevent economic stagnation.

Old bulls versus younger bears. This could be entirely coincidental. Has anyone noticed that bullish sentiment seems correlated with age?

Bullish and Buying

While heavily indebted American consumers struggle to make mortgage and credit card payments, a larger shift is underway. News from Tokyo indicates that politicians in Japan, America's "friendly" creditor nation, are beginning to consider investing the country's massive horde of foreign reserves, in order to "take advantage of the opportunities opening up around the world" during this global financial crisis we are in.

The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.

With credit tight and real estate and stocks at multi-year lows, who wins and who loses? Certainly, any trader short the market or long put options is making out like a bandit, while anyone long real estate and stocks is experiencing painful net worth erosion.

However, in the midst of the financial turmoil we're in, how's the "average American" faring? For insight, let's first have a look at household balance sheets.

I look out my office window and see a suburban scene pretty much as usual--a few parked cars, an occasional pedestrian, a tree-lined street, a bird flying by. Yet the headlines say we are in the midst of the worst financial crisis since the Great Depression:

• Fannie Mae (FNM) and Freddie Mac (FRE) are bailed out by the government.
• Bear Stearns (BSC) is forced into a government-orchestrated sale to JPMorgan (JPM).
• Lehman (LEH) goes bankrupt.
• Bank of America (BAC) is buying out Merrill (MER).
• AIG (AIG) is fighting to avoid becoming an 80% government-owned company.
• Morgan Stanley (MS) takes a 10% to 20% investment from Mitsubishi UFJ.
• Citi (C) is surviving, but staggers around like a wounded elephant with arrows in its back.

Moreover, many pundits say we have not yet reached the bottom.

Reader's Question: My husband and I are 40 years old, live in Australia, and have no kids. We own a small business and have annual income between $80k and $100k. We live within our means, have no debt, and save about $30k to $50k per year. We do not contribute to superannuation (tax-advantaged retirement plan) because we prefer to manage our investments on our own.

Our savings and investments (mostly common stock) are currently worth about $400k. Instead of buying a house, we have chosen to rent, since local real estate prices are very inflated, making renting much cheaper than buying. However, I am wondering if we should invest in real estate so as to diversify and have some place to live further down the line. How do you see renting vs. buying? Do you think we are on the right track to a comfortable retirement in about 15-20 years?

Reader's Question: I'm 28 years old. My wife and I both work as electrical engineers in jobs that pay well. Using our savings we have been buying income-producing real estate to replace our employment income, and now own 11 units. Is real estate the best vehicle for achieving our goal of becoming financially independent to free up time for activities we consider more meaningful? I have not found other investments that offer such handsome cash yields and permit a similar degree of leverage. Also, regarding leverage, what is the optimal amount of overall leverage for our property portfolio? Is it wise to "lever to the max" with exotic strategies (like wrap notes on properties purchased subject-to), or would we be better off de-leveraging our portfolio so that we don’t need to keep as much cash on hand to cover downside risk associated with leverage? I am struggling with the correct amount of property to purchase given our cash reserves.

In asset allocation and capital structure, the two areas of portfolio management your questions relate to, there are many different investing approaches, each of which has its own merits and unwavering supporters. Rather than try to show in any objective sense that one approach is always superior to the others, I will provide a personal perspective based on my own investing experiences, going broader than your specific inquiry to provide a fuller picture of what has worked for me over the past 25 years. I hope anyone reading this article is able to benefit from what I have to say; however, since even small differences in personal circumstances and preferences can sometimes lead to very different choices and approaches to investing, I encourage you to consider my opinions only as a point of reference, while proceeding to seek out advice from professionals who have the time and expertise to understand your situation thoroughly and work with you more closely to achieve your goals.

Your question pertains specifically to exchange-traded funds (ETFs), however, because the buy-and-hold versus trade decision is basically the same for individual stocks, I will answer within the general context of equity-style investing.

Reader's Question: Do you think the U.S. stock market will provide at least 10% to 20% returns over the next one to two years? Also, how about foreign equity markets?

I am bullish on equities over the long term, and think it very possible that the U.S. stock market will see returns around the level you indicate. Negative factors, such as softness in residential real estate, sub-prime debt problems, possibility of recession, record high oil prices, weakening dollar, have the potential to derail the current bull market, and will continue to worry investors. Nevertheless, despite the short-term negatives, equity markets tend to exhibit a secular rise on the back of economic growth, and this long-term trend, with solid footing in our world's market economy and capitalism, is unlikely to subside anytime soon.

Popular measures of investor sentiment are reported in Barron's each week. For brief background reading, try the Investopedia article entitled "Investors Intelligence Sentiment Index." The article cites an academic study published in 2000 by Ken Fisher and Meir Statman that concluded:

We found the relationship between the sentiment of newsletter writers as measured by the Investors Intelligence survey and future S&P 500 returns to be negative, but not statistically significant.

Reader's Question: I have a started to pay attention to PEG ratios. Can you please explain how to calculate the PEG ratio for a stock? Can you show how Apple's (Nasdaq: AAPL) PEG is 1.6, as you indicated in an earlier post? How can PEG be used to value stocks? What is a good source for finding estimated five-year growth rates?

Calculation of PEG

First of all, regarding the JP Morgan analyst's 2007 Q3 revenue cut from $67.9 million to $65.7 million (that's just 3%), I tend to agree in principle with Jim Cramer's comment that it "means nothing to me" - since it's the company's underlying business that drives the stock price in the long run, not what analysts say or write, and, in any event, the analyst, Dick Wei, maintains his overweight rating on Baidu with a price target of $400. I also think that there's a lot of truth in Cramer's remark that "the stock is going to $500." However, I do not know if it will take months or years to get there and, if Baidu's recent trading pattern is any indication, the ride from here to $500 is likely to be a very volatile one.

Reader's Question: What causes asset price bubbles? Have Chinese stocks reached bubble levels? Can you share your perspective on the potential for a Chinese stock market crash?

The Logic of Asset Bubbles

Given the commonly accepted conclusion (with 20/20 hindsight, of course) that the Japanese stock and real estate markets around 1990, dot-com stocks in the year 2000, and current U.S. housing market (now beginning to deflate) are all notable examples of asset price bubbles, and that at least some people are smart enough to learn from the past, it would seem logically to follow that either:

Are stocks with high price-to-book ratio (P/B) such as Boeing (BA) and Apple (AAPL) worth buying? Is P/E always more important than P/B? Is there any benchmark for P/E and P/B ratios by sector and industry?

High P/B ratio is often a sign that a business has rosier future prospects than its past performance. Share price is high relative to book value because investors have bid up the share price based on expectations of better earnings and/or cash flow ahead.

First of all, congratulations on being fortunate enough to have a such a sizeable chunk of cash to invest at such a early age! Please do all that you can to learn how to invest it wisely and make it grow. Sustained success in investing your own capital can set you up for a more comfortable and fulfilling life in your many decades of adulthood ahead.

I will assume that you are investing to maximize your total return over at least the next five or ten years before you head off to college, and that your parents are providing you with food, clothing and shelter, so that you really do not have a need to generate much investment income. I think you are right in choosing to deploy virtually all of your investment capital into equities, since, as Wharton finance professor, Jeremy Siegel, is quick to point out, stocks have a robust track record of outperforming bonds and cash over the long haul.

What you appear to be looking for is a reputable national or regional real estate syndication company through which to invest, relying on their deal-sourcing and management expertise to achieve solid returns in commercial real estate. I will assume for the sake of this discussion that as a small investor you are looking to invest anywhere from a few thousand dollars to a few tens of thousands of dollars, but not much more than about $100,000 to begin with.

Basically, there are two primary avenues for achieving exposure to commercial real estate:

What Drives Equities Higher?

We have seen how over the past 15 years stocks (and real estate) have outperformed bonds and cash. This tendency of equities to beat fixed-income instruments over the long haul is a familiar pattern. As I discussed a couple of years ago, the historical record shows that stocks have generally outperformed bonds across international markets from as far back as the data go (i.e., from the late 1800s to the present). For anyone interested, see books such as Jeremy Siegel's Stocks for the Long Run and Elroy Dimson's Triumph of the Optimists, both published in 2002, for informative background reading on the topic.

Brief Review of Sales History

Starting with Nintendo, let's go back in time a product cycle or two and review the competitive landscape [data for figure below come from financial reports on Nintendo's website]. Back in the year 2000, sales of the fifth generation devices, Nintendo 64 [launched in 1996] and GameBoy Color [launched in 1998], were still going strong. In 2001, Nintendo entered the sixth generation with launch of both the GameCube console and the GameBoy Advance handheld. Over the next five years, GameCube's cumulative worldwide sales [21 million units] fell dramatically short of Sony's PS2 [106 million units] and even underperformed newcomer Microsoft's Xbox [24 million units]. Nintendo, however, has had notable success in the handheld area. GameBoy Advance and its upgrade, GameBoy Advance SP [launched in 2003], together have sold 77 million units. The seventh generation handhelds, Nintendo DS [launched in 2004] and DS Lite [launched earlier this year], are proving even more popular, already selling a record 30 million units within the first two years of product launch. Overall, in transitioning from one generation to the next, Nintendo has managed to maintain total annual unit sales in the 23 million to 26 million range between 2000 and 2006. With current sales of the DS and Wii going strong, the company is now anticipating that the DS and Wii will do better than forecast at the end of October.