Whether you long for Reagan’s Morning in America, voted for Obama’s Hope and Change, or to Make America Great Again, you have found the right place because SOLUTIONOMICS is about solutions, not politics.
It’s not left, it’s not right, it’s about ROI. Implementing a decision-making process based on return on investment “ROI” is the first step in improving our economic and political systems.
Working over twenty five years in America’s financial sector for both large and small companies and now as the director of research and strategy for a $10 billion institutional investment fund manager, I have experienced firsthand what drives economic growth, what stimulates job and wage growth. And I’ve seen up close both how the financial sector operates and its role within the economy. My experience also includes advising the Chicago and Washington, D.C. districts of the U.S. Federal Reserve as well as CalPERS, the largest U.S. public pension fund.
Cash and cash equivalents “Cash” are typically thought of as low return, low risk, and rightly so. Yet, during periods like today characterized by a disconnect between depressed (and fragile) economic activity and equity market valuations, cash can hold the key to achieving the highest possible returns. How? Cash is much more than a direct source of returns; it is the great return enabler.
Cash and cash equivalents “Cash” such as short-term U.S.
Treasury Bills historically have delivered the lowest average annual returns as
shown in the chart below.
Source: NYU Stern
The disparity between Cash returns and other investments is
even greater when looking at more recent history. As shown in chart below, Cash earned less
than 1% on average since 2010 when bonds earned more than 7% and stocks earned
14% on average.
Source: NYU Stern
Given the paltry return history of Cash and today’s
extraordinarily low interest rate environment, how am I concluding that Cash is
the key to achieving today’s greatest possible returns?
Seeing Beyond Cash’s Returns
While Cash itself is expected to generate minimal returns, Cash
is much more than a direct source of returns, it is the great return enabler.
Investors often evaluate cash based solely on the returns it
is expected to generate. This leads
investors to hold minimal cash in favor of other investments expected to earn
greater returns. It is not uncommon to
hear investors say, “I can’t afford to hold cash”. When investors do hold cash, they do either
on a temporary basis until they reallocate the capital or as a small buffer
against market volatility.
However, in investment environments like we are in today, Cash can play an invaluable role, that of return enabler. Cash’s role in achieving the highest potential returns today comes not from the expected returns of cash itself, but from what Cash’s presence in a portfolio allows an investor to do – buy stocks when prices are depressed.
Buying low and selling high begins with having the capital
to buy low. However, by the time stock
prices have fallen, many other asset values have declined as well making it
difficult to raise the capital necessary to take advantage of the buying
Investors with limited Cash during periods of stock market
declines lose twice:
First, they suffer losses from the decline in
Second, they have limited capacity, if at all,
to take advantage of depressed market prices.
While Cash itself may
generate unimpressive returns, investors with Cash are able to buy assets on
“sale” when markets decline. Conversely,
other investors are left with losses and limited capacity to take advantage of
the buying opportunity.
The first step is to decide whether you think equity prices may
fall significantly over the next six to twelve months i.e. will there be an
opportunity to buy stocks at a discount to today’s prices. I outlined my views on this question on the
Solutionomics.org website in a research piece titled, “Anatomy of the Coming
Market Decline: Frenzy, Fear, Fizzle,
and Fall”. Additionally, the
appendix of this piece includes my thoughts on the some of the latest economic
developments and equity pricing.
The second step is to decide how much cash to hold. A good starting point is your long-term target cash allocation. From there, decide how much more cash you want to hold. This isn’t an all or nothing exercise. It is a question of mix. The key is to consider how much cash you want to have available to buy stocks in the event stock prices fall meaningfully. Cash isn’t just about reducing exposure to stock market declines it is about having the capacity to profit from the declines.
While some may say they cannot afford to hold Cash given
today’s low interest rates, I say that today an investor cannot afford to not
hold more Cash than usual give the economic environment and equity market pricing. Without Cash, investors may miss out on a
great stock buying opportunity as well as the opportunity to reduce their
portfolio’s exposure to the possibility of significant stock market losses.
Besides, what is the risk in holding cash? It is that stock prices keep going up and
investors miss out. This is known as FOMO.
But beware of FOMO for it may cause you to miss out on a far greater
return opportunity simply because you didn’t have the cash.
Despite the recent positive reports of economic gains in
some areas of the economy, the economy remains significantly depressed.
Yes, last weeks’ job report was a surprise and welcome
relief. However, we still have double
digit unemployment, millions more without jobs than we did before the pandemic
as well as many with reduced hours.
Despite reversing trend, consumer sentiment
remains depressed from pre-pandemic highs.
Housing has shown promise, but how much of the recent
“pop” in housing was simply pent up demand that will fade and plateau well below
Restaurants operating at 50% capacity is better
than nothing but certainly not enough to operate profitably and remain open
Retail sales had a healthy bounce, but they too remain
well below pre-COVID-19 levels and the list goes on.
So, despite the recent gains we remain in a severely depress
economic environment. If that is not concerning
enough, the nascent gains may be unsustainable.
While most believe the worst of the economic environment is behind us,
it may not be.
Over half the gains in the recent jobs report were
concentrated in leisure and hospitality (2,100,00) and retail (740,000). Besides accounting for more than half the job
gains, they are also the most dependent on consumers’ ability and just as
importantly, willingness to circulate.
How likely are consumers to continue circulating at even today’s
In only two months the number of weekly infections in the
FAACT states (Florida, Alabama, Arizona, California, and Texas) has increased
more than 700%, and the rate of increase is accelerating.
Government officials in these states have responded with
varying degrees of restrictions.
Additionally, how willing will consumers be to keep going to
their favorite restaurants, stores, weekend getaways, and other high-traffic
businesses as they increasingly know of friends and family impacted by
Source: USA Facts
Some may counter that these are just limited hotspots and
that the rest of the country is improving significantly.
First, while only five states, the FAACT states represent
nearly 1/3 of the U.S. population and GDP.
Source: USA Facts
Second, as the chart below shows, after temporarily
declining, the non-FAACT states are now also seeing their weekly number of
Source: USA Facts
Equity Market Pricing
Despite the depressed economic environment and uncertainty regarding maintaining the nascent economic gains, equity markets continue to defy economic gravity having roared back from their March lows with the NASDAQ having even eclipsed its pre-pandemic highs. FOMO (fear of missing out) seems to have returned replacing fear.
Source: MarketWatch data
Given the ongoing state of depressed economic activity and possibility
of giving back even the limited economic gains, today’s stock market valuations
are built on less than firm ground.
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