Holding excess cash is usually a poor investment strategy in an inflationary environment. There are however times when going back to harbour and figure things out is the right thing to do. It is under such circumstances that increasing the proportion of cash balances is the sensible thing to do for many investors. As trader Stan Jonas once eloquently explained in the movie from 2000 about the fall of Long Term Capital Management; The Trillion Dollar Bet,
When do you admit that you're wrong, start all over again. Or when do you hang on and assume that the markets will turn around in your way. That's the biggest decision we all have to make. However, there is one thing that is clear. Over the last several hundred years we've been able to identify some people that can do it better than others. They don't necessarily go to MIT, they don't necessarily have degrees in mathematics so that doesn't automatically rule them out. They are the kind of people that can make that judgement that says something's different here, I'm going back to harbour until I figure it out. Those are the kind of people you want running your money.
It is my view that now is the time to get back to harbour or at least steer towards it for those who can.
Therefore, in this article I discuss five factors that are now increasingly strengthening the case for investors, especially those invested heavily in stocks, to increase their proportion of cash holdings. These are,
- A richly valued stock market that has greatly dislocated from key fundamentals
- A long period of financial stability and low uncertainty as measured by financial stress indicators
- A money supply growth rate that is heading down
- Rising interest rates
- A personal saving rate hovering near record lows
The focus of this article is the purchasing power of money as it can have a driving force of its own one the prices of goods, services, and assets money is exchanged for. Before discussing five factors that combined make up the case for cash in this article, here is a necessary theoretical background of the determinants of the purchasing power of money.
The Purchasing Power of Money
As is the case with any other good, the price of money is also determined by the valuations of market participants.
There are two characteristics of money however that distinguishes it from all other goods. Firstly, money is never consumed, but is instead used again and again in exchanges for other goods that are consumed. Money is therefore valuable because of what it can obtain in an exchange, and not in and of itself. That is, the paper money employed today has no value in nonmonetary uses, i.e. it has no intrinsic value. Secondly, the supply of money is not generated by the market, but by the banking system (predominantly central- and commercial banks) which has a monopoly on the issuance and destruction of money. Thirdly, while the production of all other goods require some sort of sacrifice in the form of labour, postponed consumption, and investments, today's fiat money is created effortlessly and electronically by banks and central banks at no or little direct cost. Finally, at the end of the day the the purchasing power of money (PPM) is determined by the relationship between the demand for money and the supply of money; the money relation.
Simply stated, the reciprocal of money prices (goods quoted in terms of money, e.g. $3.50 for a hamburger) is the purchasing power of money. An increase in the supply of money will make the purchasing power of a currency lower than otherwise.
Since the PPM is determined by what and how much it can obtain in exchanges, a decreased PPM means money has become less valuable compared to what it can be exchanged for. That is, the purchasing power of the goods, services, or assets that can be exchanged for money have increased in price relative to money. Hence, when stock prices rise, the purchasing power of money compared to stocks falls. This is the equivalent of saying that the purchasing power of stocks relative to money has risen since shareholders can now exchange their stocks for more money than they previously could.
The supply of money increases whenever banks expand credit or when the central bank monetises debt (here). Since the banking system seeks continuous inflation, the resulting increase in the supply of money over time tends to push up the prices of most items that increases in quantity at a slower pace than the quantity of money. This explains for example why the prices of real estate and commodities tend to increase with time in tandem with an inflating money supply.
The same process also explains why broad stock market indices tend to increase in price over time. It also helps explain the great success buy and hold investors have had for many decades and why ordinary savings depositors have done terribly. Essentially, stock prices in the aggregate rise over the longer term not due to productivity increases or new inventions, but mostly due to increases in the money supply. Simply put, it is the ever-inflating quantity of money that allows the majority of prices quoted in money, including stock market- and other asset prices, to rise over time (see here for a detailed account).
If the money supply did not expand over time, prices in general would have to come down for the market to clear in a progressing economy because ever more goods, services, investment projects, and so forth would be chasing the same amount of money.
Key determinants of the purchasing power of money (PPM) over the longer term in the U.S. and in other mixed economies employing soft currencies are therefore, the supply of money (fully controlled by the banking system) and the level of real output (largely controlled by market forces).
All other things remaining the same, the PPM declines (prices increase) when the money supply increases and when output decreases. Conversely, the PPM increases (prices decline) when the money supply contracts or when the level of output increases. Maximum price inflation therefore occurs when the money supply expands in tandem with a contraction in real output. In extreme cases, hyperinflation ensues. On the other hand, maximum price deflation will occur when the money supply contracts while real output increases.
The shorter term is a different story however as another key determinant of the PPM comes into play: the demand to hold cash. This factor is of great significance to prices in general for two primary reasons. Firstly, changes in the demand to hold cash affect the quantity of money available in exchange. When the demand for cash increases, there will be less money chasing existing goods and services as money-owners decide spend less. This exerts a deflationary pressure on prices. The opposite happens when the demand for cash to hold decreases. Secondly, the demand for cash to hold can change rapidly and substantially faster than changes in the money supply and output ever can (absent a natural disaster on a grand scale, a country ravaged by war etc.).
Given this great influence on prices, a rapidly declining demand for cash to hold may contribute to the creation of hyperinflation. This is typically associated with highly inflationary environments where people see no end to the inflation. People may then act by exchanging money for almost anything since money will be substantially less worth tomorrow.
But when the demand for cash to hold increases rapidly, the central banker's nightmare becomes reality: prices collapse. That is to say, the PPM increases rapidly. This is a hallmark of a financial crisis and a stock market crash. It is especially at this point that the market value of money (the PPM) surges. It is also at this stage that investor regret sets in for those that abstained from increasing their allocations to cash beforehand.
Five Factors Supporting The Case For Cash.
Identifying the factors that could trigger a substantial increase in the PPM is therefore essential for limiting losses and maximising returns. Below I address some of these key factors and where they currently stand.
- The richly valued stock market suggests there are limits to how much further the value of cash can depreciate versus stocks. There is however ample room for cash to appreciate compared to stocks.
- Low levels of uncertainty as measured by a range of financial stress indicators suggest, if history is any guide, that a period of increased financial stress is overdue. For example, the St. Louis Fed Financial Stress Index has, bar a modest spike in early 2016, been at historically low levels during the last five years. When financial stress increases, the PPM will most likely increase as well.
- The money supply growth rate is declining. The medium- to longer term growth rates of the money supply have fallen sharply recently. On a shorter term basis, the money supply is actually contracting. As the rate of increase in the supply of money decreases, the PPM will likely gradually increase or at worst, decline less than previously.
- Interest rates are increasing. The effective federal funds rate is now around 0.9%, up from 0.15% in late 2015, while 3-month LIBOR is up almost 100 basis points. This will make credit more expensive which can drive the PPM higher as money becomes more "scarce" (i.e. prices are too high).
- Relatively low levels of saving. The personal saving rate is these days fluctuating around 5.5%, 1.9 percentage point (26%) below the 7.4% average since 1973. Relative to the money supply, the saving rate has remained around historical lows more or less consistently during the last ten years: while the ratio averaged 17.7% during the 1973 to 2004 period, it has averaged a mere 7.9% thereafter. Gross private saving relative to the money supply (the inverse of the money supply to saving ratio) has been at the lowest levels ever recorded during the last few years based on data going back to 1959. Such relatively low levels of saving cannot be expected to continue for long, especially as credit growth slows and interest rates rise. When the saving rate picks up, the demand for cash balances increases accordingly which exerts upward pressure on the PPM.
All of these five factors are related in one way or more. For example, increased uncertainty will tend to raise the demand for cash balances and the rate of saving, plummeting stock prices will lead to increased uncertainty, and so forth. They all have one thing in common however: they all affect, but are also affected by, the business cycle. And based on monetary developments, the business cycle does appear to have peaked and is now heading down.
There are obviously also other factors that can affect the value of money. There are also factors that can bring about further declines in the PPM of the U.S. dollar, most notably another round of QE by the Federal Reserve.
But given where things currently stand, recent developments, historical relationships, and the theory of the business cycle, the five factors above appear to support the likelihood that the purchasing power of money could strengthen going forward, especially relative to stocks, but also relative to other asset classes. Put differently, increased demand for money to hold and a decreased supply of money can directly, and negatively, affect a range of asset prices. If this happens, which certainly looks highly possible now, substantially more shares and other financial assets can be acquired at a later stage with the same money while losses have been avoided in the mean time. And that is the case for cash.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.