No Return is Better than a Negative Return
The best time for an investor to own cash is when it pays next to nothing. This may sound counterintuitive, and it is the opposite of what most investors do when cash pays nothing: They scramble to find better-paying alternatives, even if it means taking on more risk. But the contrarian aspect of this rule has always appealed to me, and my own experience has generally vindicated it.
Personal biases aside, the most compelling argument to owning cash when interest rates are close to zero is simply that, from that point, they basically have nowhere to go but up. And when they do, sometimes with a lag but sooner or later, lower prices for stocks and bonds will result.
Why is this? Because most investments compete with the presumed riskless return on short-term government paper like Treasury bills. When interest rates on Treasury bills rise, the return on all other investment vehicles must also rise or they will lose investors.
If a bond interest rate is fixed, for example, its yield can only increase by its price going down. For stocks, things are a bit more nuanced. First of all, the cheapness or expensiveness of a stock is not measured by its dollar price, but by how that price relates to the stock’s earnings – the price/earnings ratio.
If an increase in interest rates is due principally to greater credit demand, usually a sign of faster economic growth, price/earnings ratios would likely decline but stock prices could remain resilient if corporate earnings improved with the economy.
But interest rates can also go up to compensate for an increase in the cost of living. An increase in interest rates due to higher inflation would be seen as a potential trigger for more restrictive monetary and fiscal policies, along with their frequent recessionary consequences. Then, both price/earnings ratios and earnings might suffer.
To complicate things further, the timing of these sequences of events is elusive. For example, no one really knows how long rising earnings might sustain stock prices in the face of declining price/earnings ratios. Similarly, many historical studies have documented that a slow acceleration of inflation from a low level at first tends to be a positive influence on stock prices, because it often benefits profit margins by restoring a measure of pricing power for corporations. It is only when inflation accelerates in earnest that the negative impact on profits (through higher costs), on yields, and on stock valuations reasserts itself with a vengeance.
Is the Market Ready To Withstand a Rise in Interest Rates?
Today it can be argued that the U.S. market and many others are cheap compared to 1) where they were in 2007, and 2) the alternatives (bonds with very low yields, for example).
But they are not cheap historically. Comstock Partners reminds us in a September 20, 2012, letter that “…for the century prior to the late 1990s, the S&P 500 typically peaked at 22-23 times reported earnings and troughed at 7-9 times earnings.” It is now in the middle of that range. Similarly, from a valuation perspective, few markets today seem to offer significant upward potential when compared to their long-term, historical ranges.
As for profits, there is some debate, too. Many observers, for example, feel that U.S. corporations may be hard-pressed to increase earnings when their profit margins already stand at an all-time record. Certainly, the share of services in the economy has been growing steadily and margins in the service economy tend to be higher than those in manufacturing. It is not shocking, therefore, that overall profit margins should stand at a record. However, this does not mean that they can surge further in the near term.
Meanwhile, a headwind may be looming for U.S. corporate profits. The currencies of major emerging economies, in particular, were boosted by large inflows of capital in search of higher returns during America’s zero-interest experiment. Recently, however, the bare mention by the Federal Reserve of a possible wind-down of quantitative easing has provoked sharp corrections in several of these currencies. If these corrections continue, the translation into dollars of foreign subsidiaries’ profits may now become a negative rather a positive for U.S. corporate earnings.
In summary, it is hard to argue that either stock valuations or profit margins should leap upward from current levels; and if interest rates should spike up further, both may be vulnerable.
Picking Violets on Top of a Volcano
If I believe figures from John Mauldin Economics, the S&P 500 returned roughly 42 percent from September 1, 2011, through August 1, 2013. Over that time frame, the trailing 12-month P/E ratio jumped 44 percent, from 13.5 to 19.5. Clearly sentiment, rather than fundamentals, has been driving the markets higher, hardly reflecting any skepticism. A good example of this is Microsoft, whose shares jumped 8 percent on the recent announcement that its CEO, Steve Ballmer, would resign. No one knew who would replace him or how this might affect Microsoft strategies, but the market was willing to bet blindly that the result would be good.
I would say that complacency, if not euphoria, still reigns. While the risks present in today’s markets (financial, economic, or geopolitical) are fairly well publicized, they are hard to measure, so it is uncertain whether they are fully reflected in prices. On the other hand, the potential rewards from current levels seem paltry. If there is not much to gain, what is the point of assuming any risk?
Given this complex situation, how money managers handle risk will depend on their primary goal.
If their main motivation is to preserve the purchasing power of the patrimonies under their care, they will probably have an attitude eloquently summarized by my old friend Jean-Marie Eveillard, 2003 recipient of Morningstar’s Fund Manager Lifetime Achievement Award: “I’d rather lose half of my clients than lose half of my clients’ money.” In other words, they won’t mind sitting with idle cash in a rising but suspicious market.
If, on the other hand, money managers have joined the perverse game of “relative” performance encouraged by (not all, but too many) asset allocators and consultants, they necessarily will have a motivation that has more to do with marketing products or services than preserving clients’ financial well-being. Nowadays, marketing necessitates quarterly performance and volatility measurement, which impose on managers a bias for short-term gain that has seldom been the key to durable success. In the words of Charlie Munger (Warren Buffet’s long-time partner and friend, speaking about sector rotation), “All I know is that all the people I know who got rich – and I know a lot of them – did not do it that way.”
The attitude of many professional investors towards the current market makes me think of a crowd enjoying a dance party on top of an active volcano. They know it is going to erupt but, instead of planning an exit, they keep dancing while trying to guess the exact date and time of the eruption. This is sadly reminiscent of the statement by Charles Prince, who presided as CEO over Citigroup’s $64 billion loss of market value during the sub-prime meltdown: “As long as the music is playing, you’ve got to get up and dance.” This may be the attitude if you are dealing with O.P.M. (Other People’s Money). But if it is your money, cash is an alternative.
Postponing the Day of Reckoning
The frustrating thing is that most of the above could have been written at almost any time during the past year. So, how long do we have to wait for historical logic to reassert itself?
Without subscribing to the TTID (“this time is different”) school of economics, one must admit that,
The world’s central banks are engaged in one of the great policy experiments in modern history: ultra-easy money...Nothing like it has ever been seen before at the global level, not even in the depths of the Great Depression. (William White, former deputy governor of the Bank of Canada, “The Ultra Easy Money Experiment,” Project Syndicate, 6/12/2013)
Monetarists have a simple (and thus credible) explanation for inflation: It happens when money-supply growth persistently exceeds output growth. Yet, although Prof. Allan H. Meltzer, of Carnegie Mellon University, observes that “The Fed has printed reserves with reckless abandon,” there has been no sign of accelerating inflation. So, what’s going on?
Harvard Professor Martin Feldstein provides an answer to this apparent contradiction: “The puzzle disappears when we recognize that quantitative easing is not the same as printing money” (“Why Is Inflation so Low?” Project Syndicate, 6/28/2013).
As a reminder, when the Fed buys bonds or other assets from the public it basically does so by crediting with newly created money the seller’s checking deposit at a commercial bank. Commercial banks, in turn, are required to hold cash reserves at the Fed equal to a proportion of their deposits.
Before 2008, reserves in excess of the required amount did not earn any interest from the Fed, and commercial banks thus had an incentive to lend to households and businesses. Since creating new deposits extends banks’ new loans, they are, by definition, an increase in the stock of money. Of course, an increase in bank loans also allows households and businesses to increase their spending. That extra spending means a higher level of nominal GDP, some of which takes the form of higher real (inflation-adjusted) GDP, while the rest shows up as inflation. This process explains how Fed bond purchases have historically increased the stock of money and the rate of inflation. But in 2008, the Fed began to pay interest on excess reserves.
Quoting from Prof. Feldstein’s paper:
The interest rate on these totally safe and liquid deposits induced the banks to maintain excess reserves at the Fed instead of lending and creating deposits…As a result, the volume of excess reserves held at the Fed increased dramatically from less than $2 billion in 2008 to $1.8 trillion now. But the new Fed policy of paying interest on excess reserves meant that this increased availability of excess reserves did not lead after 2008 to much faster deposit growth and a much larger stock of money…The size of the broad money stock (known as M2) grew at an average rate of just 6.2 percent a year from the end of 2008 to the end of 2012.
…So it is not surprising that inflation has remained so moderate – indeed, lower than in any decade since the end of World War II. And it is also not surprising that quantitative easing has done so little to increase nominal spending and real economic activity.
When Better Is Not so Good
For much of the past year, there have been clear signs that global stock markets have become addicted to monetary quantitative easing. In fact, it has become the norm that markets surge when economic indicators weaken and correct down when the economic recovery seems to accelerate. Witness the headline crossing the tape as I am writing this: “U.S. equity futures move higher in reaction to the weaker than expected jobs number.”
The rationale for this seeming paradox is that a subdued economy offers investors the promise of more quantitative easing, which tends to flood financial markets with liquidity as long as the economy remains weak. An accelerating economic recovery, on the other hand, would be viewed as a threat to the policies of quantitative easing and to financial liquidity.
I have long argued that the post-crisis recovery would take a long time and tend to be tentative. But there is no reason to believe that the global economy will never fully recover. And when it does, interest rates will rise. The spike of U.S. interest rates when the Federal Reserve announced a possible “tapering” of its easy monetary policy should serve as a warning signal that the exit from quantitative easing may not be as smooth as central bankers would wish. Kiril Sokolov, of 13D Research, indicated in a recent letter (8/22) that “some funds have encountered real difficulty exiting their positions in AAA securities,” and projected that “the rush towards the exits is likely to extend for months.”
And, in our increasingly global and integrated economies and markets, the problem may not be limited to the United States, which makes it more difficult to assess the true size of the challenge. Stephen Roach, former chairman of Morgan Stanley Asia, recently pointed out that, as the surplus of yield-seeking capital from investors into developed countries starts flowing back out, “Many high-flying emerging economies suddenly find themselves in a vise. Currency and stock markets in India and Indonesia are plunging, with collateral damage evident in Brazil, South Africa, and Turkey” (“The Global QE Exit Crisis,” Project Syndicate, 8/20/2013).
Conclusion
It is sad that some of our best economists are remembered primarily for statements that sound like platitudes. For example, William McChesney Martin, who was Fed Chairman for 19 years (1951-1970), is best remembered for the definition he gave of his job: “to take away the punch bowl just when the party gets going.” Herbert Stein, chairman of the Council of Economic Advisers under presidents Nixon and Ford, remains famous for his observation, “If something cannot go on forever, it will stop.”
But platitudes have one great advantage: They are rooted in common sense and real-life experience. This is why we should try to remember Nobel Prize winner Milton Friedman’s warning: “Inflation is always and everywhere a monetary phenomenon.” I am not sure where the corner is, but it is probable that inflation is just around it, together with higher interest rates and their consequences. Until this happens, “There's nothing wrong with cash. It gives you time to think” (Robert Prechter Jr.).
François D. Sicart is Founder and Chairman of Tocqueville Management Corporation, the general partner of Tocqueville Asset Management L.P. Prior to founding Tocqueville Asset Management in 1985, Mr. Sicart was associated with Tucker Anthony, a New York investment firm. During his seventeen years with Tucker Anthony, he held various positions including General Partner, Vice President of Tucker Anthony, Inc., and Vice Chairman of Tucker Anthony Management Company. Prior to that, Mr. Sicart served in the French Air Force and taught accounting and finance for two years. Mr. Sicart earned an M.B.A. from École des Hautes Études Commerciales (H.E.C.), the leading business school in France. He is also a director of Lepercq Amcur SICAV FIS and a member of the strategy committee of Banque Quilvest.
Disclosure: This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.