Suddenly, cash has rarity value
When should you hold more cash? The simple answer is: when fewer people are holding it. Because that’s when it’s most valuable. And, right now, after the stampede to other asset classes, cash is more valuable than it has been for some time.
When central banks around the world acted collectively to drive short term interest rates to zero and then to flatten the yield curve by also buying global long term bonds, they triggered a mass migration of investors out of cash and into every other asset class.
As US 10 year bonds fell from nearly 16% in 1980 to 1.36% last year, yields on all assets fell amid a migratory buying frenzy that ignored quality and longer-term growth prospects. The yield on the S&P500 has declined from above 6% in 1981 to just over 2% today. In 1992 Australian industrial property offered a yield of 12%, today it offers about 6.5%. Retail property offered 9% in 1992 and today it is 5.75%. A year ago, triple-C rated bonds (Junk Bonds issued by the highest risk companies) yielded 9% more than bonds issued by the US Treasury. Today that difference is just 4%. Hong Kong residential property yields have declined from over 11% in 1982 to less than 3% today, and in Australia residential yields of over 9% in 1987 have fallen to less than 3%. Bond proxy infrastructure stocks Transurban and Sydney Airport have seen their dividend yield fall from more than 12% in 2008/09 to less than 6% today.
If you aren’t selling the above assets at today’s prices you are effectively buying and what you are buying is a long duration asset with an inadequate income. The classic response of course is that while the income is poor investors will do well from capital gains. This misses the point that in order to make a capital gain the next buyer one sells to has to accept an even lower yield. Capital gains don’t occur in a vacuum. In order to sell there must be a buyer, and that buyer must be an even greater fool to accept an even lower yield.
Of course, there is nothing to worry about right now – everything appears rosy and asset prices aren’t falling. Why be concerned? Quite simply, as bond rates continue rising from their recent lows, the fixed incomes of many assets will be less valuable. Investors will start reappraising their investment strategies and they will question the sense of locking in such low returns for multi-decade periods on multi-decade assets.
And that’s where liquidity becomes important. I completely understand the logic of not holding cash in a low interest rate environment. Cash only yields 2.5%. But now many less liquid assets yield the same amount but with much higher capital risks and far less liquidity. I challenge 20,000 readers to try and sell their leveraged apartment at a 10% profit today. I’d be surprised if in aggregate that is possible. I challenge 100,000 readers to sell their recently purchased leveraged apartment at break even! As billionaire Sam Zell once observed, liquidity is value. Only when you can actually sell is the value you have put on your asset correct. In a market full of investors trying to exit, market values will change suddenly.
So ask yourself: if I need to get out in a hurry, will I be able? If you aren’t leveraged and you don’t mind riding a cycle or two, you have little to worry about. And if you have another income stream that allows you to add to your portfolio at lower prices, again you have little to worry about. But cash is most valuable when nobody has any. And given the migration that drove asset prices higher, few have any. If there’s a migration back to cash, illiquidity could trigger a significant fall in asset prices.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Rod Schofield
:
Thanks for this Roger,
I’m curious about the notion of ‘capital’ gain as an argument for holding on. Has the word ‘capital’ lulled so called investors into a false sense of security.
Is it really just price gain. It’s a market just like the stock market isn’t it, and one can’t go and shop for the groceries and pay the rent with such gains until the so called asset has been sold.
Roger Montgomery
:
correct Rod.
simon
:
HI Roger
read this one….interesting
Paul Black of WCM Investments prefers to hire generalist analysts rather than sector specialists because they believe they’re more likely to see the bigger picture on a theme.
“I have said to the research guys, get out of the office, get away from your screen. Go to the beach, pull out a chair and read a thought piece.”
“Read a good book about an industry. Get on the road. Walk the street. Figure out what is going on. That will give you an advantage.”
Black says it’s no surprise most managers are battling to beat the index given they all think and act alike. And he’s particularly scathing of managers that formulaically apply the tenets of value investing – which is to buy “quality” businesses at below intrinsic value.
“In our minds, 40 years ago when Buffet popularised it, there were inefficiencies. But today we would argue there are none.”
“If you are doing what everyone else is doing it makes complete sense that you are not going to outperform – there is nothing unique.”
Read more: http://www.afr.com/business/banking-and-finance/hedge-funds/wcm-how-laguna-beachs-super-stock-pickers-beat-the-market-and-live-the-dream-20170519-gw96xs#ixzz4hs9PV7Lm
Roger Montgomery
:
Hi Simon,
We were very interested in his comments about expanding economic moats – which is something we think about here at Montgomery all the time. We also visited their website and looked at their long term fund performances and weren’t bowled over in amazement.
Chris
:
Roger,
In that case, given that in the longer term, “everything reverts to the median” and thus the over-priced / under-priced assets, whilst swinging around and lurching between the two extremes, must do the same. In other words, whatever the “long-term” yield is on these assets, as a simple mathematical function of numerator / denominator, the price must come back down (or go up to) a “more realistic” level.
From readily available data and a simple spreadsheet, I’ve found that the average of the dividend yields of the S&P500 (from 1960 to 2015) was 3.05% and a median of 3.08%, despite the fact that since 2011, US companies have significantly increased their earnings since 2010, with an even more pronounced hike if it is considered since 2007, versus modestly improving their dividends since 2010 and particularly so since 2007. Payout ratios have averaged around 45%, yet are currently around 35% on (now) flat earnings.
What does this mean to me ? That US companies are flush with cash but are retaining it (but for what ? You can only do certain things with it – one is a buybacks, but these are only any good when shares are undervalued but I would say that very few US businesses would be at current S&P500 valuations. Second is a dividend, but payout ratios are lower than the historical average and so are dividend yields, and third is to embark on M+A activity, which, seems like overpaying for businesses at these valuations and a great way to destroy shareholder’s wealth).
If you were therefore to buy the S&P500 as a business that paid 45% of it’s earnings as a dividend, bearing in mind that earnings change much slower than the price (therefore, consider them ‘static’), my numbers tell me it should be more likely around the 1,800 level. Even the institutions are saying that “the S&P500 will need an earnings miracle” to lift the denominator part of the simple “price to earnings” valuation metric.
I know this sounds simplistic, but to me, the prices being paid don’t even make sense in these ‘simple’ terms and if you can’t explain it in those, something is wrong.
Jason
:
Hold cash, but in which currency. Are there any currencies more favourable in your view
than others at the moment?
Roger Montgomery
:
One would reasonably conclude, USD, and Euro or GBP. Some strategist friends of mine suggest not Yen or Aud. Currency trading is speculation most of the time.