Why cash isn’t king

Bottom line up top?

You can’t set your watch to markets. The modern one-year anniversary gift is a clock – a fitting metaphor for today’s market conditions. It took roughly one trip around the sun for the lagged effects of tighter monetary policy to manifest in the form of banking sector instability, which has dramatically shifted the expected timing for rate cuts. Unfortunately for investors, the end of this tightening cycle cannot be determined by a timepiece. The proverbial bell will toll for rate hikes due to either continued financial sector turmoil or marked declines in wage inflation, manufacturing activity, earnings, or employment – circumstances which are also likely to ring in the start of a recession.

More is lost by indecision than no decision. Buying low and selling high is the goal of every investor – and periods of heightened uncertainty often lead to an increased number of investors attempting to avoid losses by hoarding cash, awaiting the “right” time to reinvest. In the current environment, those staying in cash or short-term government bonds and trying to guess when markets have troughed based on monetary policy expectations are likely to find themselves with more regret than gains. Notably, history shows a wide range of equity market returns as monetary policy loosens (Figure 1). Furthermore, an examination of the S&P 500’s historical returns reveals that investors who missed the best 10 days over the past 30 years underperformed the Index by 54%; and missing the best 20 days led to underperformance of 73%. As a result, we encourage investors to remain invested and highly selective, seeking quality stocks with a history of dividend growth, or, perhaps more prudently, adding to core-plus sectors of fixed income.

Portfolio considerations

Amid higher interest rates, economic uncertainty and (most recently) banking sector turmoil, many investors have moved into higher-than-typical allocations to cash or short-term government bonds. As rates have rapidly shot up over the past year, and with cash yielding close to 5%, some have taken a little risk off the table, awaiting a potentially more attractive entry point. We think this approach is a mistake as market timing almost never works and investors run the risk of missing significant upside as markets can rebound quickly. We believe in remaining fully invested and allocating to asset classes that can perform well during volatility with potential upside capture if the economy performs better than expected. This leads us to favor dividend growth within equities and core-plus fixed income strategies.

Dividend growth offers the potential for downside protection, while also offering opportunities to participate in rallies. Our research shows the S&P 500 Dividend Aristocrats Index offered 79% of downside capture versus the S&P 500 Index and 93% of the upside capture between November 2002 and February 2023. Companies with dividend paying stocks offer a combination of high relative yields, tend to be higher quality and have the ability to reinvest cash into their businesses. We think this sort of focus is crucial: Between 1930 to 2022, dividends made up 41% of the annualized total return of the S&P 500 Index.

Similarly, we believe core-plus fixed income strategies offer attractive yields while balancing duration and credit risk. We see value in taking on credit risk, specifically when it comes to higher quality allocations across high yield and preferreds. As we anticipate approaching the end of the U.S. rate hiking cycle and the Federal Reserve pausing, we analyzed the returns of the broad bond market versus short-term Treasuries during historic periods when the Fed paused (Figure 2). Historically, the broad bond market experienced a sharp relief rally immediately after the initial Fed pause and mostly outperformed over the next year. This lends further credence to our view that over-allocating to cash or short-term government bonds may be a mistake.