Opinion

James Saft

Cash bites, but hold some anyway

July 31, 2013

By James Saft

(Reuters) – Cash: it loses value every day, will permanently impair your portfolio if you hold it long enough, but just might be your most important allocation right now.

Cash is not an investment I love; in fact, it is lousy, for reasons I will shortly explain. What cash is, however, is an option on future opportunities; powder to be used when prices are more attractive later.

With the prices on almost everything else available so high, and the risks from monetary policy similarly high, cash, while trash today, can be recycled into something a lot more valuable tomorrow.

The problem with cash, of course, is that, while inflation is low, short-term interest rates are even lower, with a typical money market account yielding just 0.40 percent, according to bankrate.com, or 0.60 percent if you can scrape together $50,000.

That ensures that you are losing purchasing power every day; do it long enough and it adds up. Dylan Grice, of fund managers Edelweiss Holdings, points out that $100 held on deposit since 2009 has about $90 of purchasing power today.

That is precisely what ultra-low interest rates and quantitative easing are intended to do: to force investors to take on more risk, and in so doing drive the value of assets higher and, supposedly, help the economy to heal.

Whether this works as monetary policy is unproven, but as a means to drive up the prices of financial assets it has been a huge success. Stock markets in the U.S. are at record highs and even despite a recent selloff, Treasuries are also at very expensive levels.

That’s great news if you were long equities a year ago, but perhaps a less compelling reason to be long today. In fact, according to forecasts from fund managers GMO, a typical 60 percent equities/40 percent Treasuries portfolio can be expected to generate annual gains over the next seven years of less than 1 percent above inflation.

That forecast is based on the assumption that interest rates revert to something closer to their historic levels. You might doubt that they will, and indeed the Federal Reserve on Wednesday announced no change in interest rate policy and no indication of the taper which the market is expecting in September.

As James Montier, strategist at GMO, points out, it is possible that the Fed chooses to keep rates low across the interest rate curve for a long time. That would improve returns for bonds, and certainly might avoid a reckoning for equities, but still on GMO’s math only brings that seven-year annualized return for a mixed portfolio to 1.7 percent above inflation.

Betting on that is a big risk:

“In owning Treasuries under the assumption that the Fed holds real cash rates negative, you get the roll return as above, but this could be described as a ‘pennies in front of a steamroller’ style strategy,” Montier writes in a note to clients. (here)

WHAT TO DO WHEN YOU DON’T KNOW WHAT TO DO

The alternatives are not attractive, but choose we must.

You could, as Montier points out, seek out corners of the market which are less overvalued and concentrate your money there. Great advice if you can see the future, but for those of us who are not clairvoyant this sounds like a good way to end up with untenable risks.

You could also seek out alternatives, in hopes that these won’t be correlated to financial assets, or have been insulated from the waves of Fed-generated money washing around the world.

This too seems unwise; as we saw in 2008 everything is correlated, and as we are seeing today in farmland and art, easy money drives the prices of every asset too high eventually.

Leverage could be another out; borrowing will magnify low returns, perhaps turning that 0.7 percent annual real return into something more palatable. It could do that, or it could break you, if for example, a sudden and unexpected rise in interest rates drove all markets lower, prompting margin calls and leaving you, poor investor, up a creek.

The last, and perhaps best option, Montier calls patience but is also known as cash.

If you are reasonably sure that overall returns will be uninspiring at current valuations, it makes sense to put aside a portion, let’s call it very low double-digits, of your money and wait for better terms later.

It has often been said that the key to investing is buying what everyone else hates. With the possible exception of gold, cash is the asset that best fits that description.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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