The Thinking Behind Why Cash Is Now Good (and not Trash)

My comments over the last couple of months that “cash is good”— which was opposite to my comment made in early 2020 that “cash is trash” — got a lot of attention prompting some people to want to know why I changed my mind.?

To be clear, what I tried to convey both times is how attractive cash is based on the interest rates offered at those times. The rates were “trashy” (less than 1 percent) back in 2020 and “pretty good” (around 5 1/2?percent) recently. ??

Sometimes cash is good and sometimes cash is bad. This is based on a number of measures I use and want to pass along so I can help you “fish” rather than give you a “fish” (i.e., a conclusion without the reasoning that led to it). I?will share a simple,?imprecise but pretty good way to assess whether cash and bonds are attractive or unattractive. While my actual process is a bit more complex than what I’m going to describe, this simple version should help explain my thinking, though I worry that it might still be a bit too complex for some. I also want to make clear that this post is about comparing the relative attractiveness of asset classes, not investing to produce alpha (which is a much different topic). Anyway, here goes.??

Most importantly, to assess the appeal of cash (and, to a large extent, bonds), I look at:

1) the levels of interest rates relative to prospective inflation rates (i.e., the real interest?rate),

2) whether the Fed is likely to tighten or ease rates based on whether inflation and growth are higher (which will make them tighten) or lower (which will lead them to ease) than the Fed wants them to be,

3) the attractiveness of the expected cash return relative to the attractiveness of other investments based on their prospective returns, and

4) the supply-demand picture for cash and bonds. ?

Now that you get the factors, I will try to be more specific.?

As a rule, I?want to lend (i.e., invest) in cash when:

a) interest rates are rising and the risk-free interest rate is more than 1 percent?above the inflation rate (the more above 1 percent, more I want to lend), and

b) when the real interest rate is at or above the economy’s real growth rate -- or said more simply, when the interest rate is above the economy's total growth rate (i.e., inflation plus real growth). The more above the inflation rate and growth rate, the more I want to lend, and I want to borrow (i.e., be short cash) when the opposites are true.

To be clear, the numbers I used were for the risk free (i.e., US Treasury) rate; I of course want a higher interest rate for riskier debt with?how much higher depending on how much riskier the debt is. I like "cash" (which I consider to be from overnight maturities to two-year maturities) on that basis (which is now) because I am capturing a pretty good rate without a risk of losing principal, and if rates keep rising I will get more and more because I didn’t fix my rate. I don’t want to own bonds (by which I mean longer-term maturities, typically 10 years or more) because their prices will fall during times when rates should rise. That’s why I told you in early 2021 that I thought it was stupid to own bonds when Treasury bond interest rates were at about 1 percent, which was about 1 1/2 percent below the prospective inflation rate, and there were good reasons for rates to rise given what prospective inflation and growth were doing. Looking at longer term bonds, I want 1 1/2 to 2 percent rate above the prospective inflation rate (which I now estimate is about 3 1/2 percent) or a real interest rate that’s above the prospective real growth rate (which looks like about 1 percent). For that reason, I’d need about a 5-5 1/2 percent Treasury bond yield to start getting interested in bonds if it were just for these drivers, but as I mentioned before, these aren’t the only drivers. ?

I also look at the supply and demand for bonds to bump my estimates. Because I now see that the prospective supply of Treasury bonds to be sold is large (because the government’s deficits are large) and the prospective demand is likely to be low (mostly because foreign buyers of bonds, banks, and central banks own a lot, have bad losses in them; they are worried about what’s going on politically, socially, and economically in the US; and also because some foreign holders of bonds are worried that they could be "sanctioned" which would mean that they couldn't convert their US bond holding into to cash that they could spend), that makes me think that higher than this roughly 5-5 1/2 percent rate might be?required to attract buyers, at least until stocks, the economy, and inflation fall. For these reasons cash (which doesn't have price risk and will become more attractive if yields rise) looks relatively attractive to me compared to bonds. As for stocks, while the analysis I do is rather complicated, I will give you a simple, albeit less precise, way of looking at them which is still pretty good.?

My approach is pretty complicated because I look at individual companies’/stocks’ earnings yields,?dividend yields, and earnings/growth prospects relative to their prices. I also look at their supplies and demands individually. Then I put this together to get my view of the total market I’m looking at (e.g., the S&P 500). You can do this more simply, albeit less precisely,?by looking at the market yield as a whole. So, what does that now show? It now shows that the stock market offers?about a 5-5 1/2 percent expected return which is pretty low in relation to bond yields (especially because bond yields could go higher which would tend to make stocks go lower). This makes the cash return, which has virtually no price risk, look pretty good relative to the prospective stock market return as well as relative to the prospective bond return. Since none of these are precise (e.g., I could see bond yields go to 5.5 or 6 percent and stock yields rise even more, hence I could see bond and stocks falling commensurately), cash offers a good return without price risk. It also keeps my money as dry powder, so cash looks “pretty good” to me.?

To reiterate, there is nothing precise about these sorts of calculations so the deviations around these estimates are often large. For that reason, I like to take action when the prospective return differences are relatively extreme as they were when rates bottomed out and I said cash was trash.?

I probably gave?you just about enough to be confused and dangerous to yourself, but I did give you the?best brief answer to the question about how I think about these things. I hope it helps you. ?

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