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The embarrassment of cash




I last touched on this topic in a post last October, and it's worth reading again. One excerpt:

To willingly hold cash that yields zero, you must be convinced that there is death and destruction awaiting at every turn. The market is climbing terrifying walls of worry, yet on the margin people are slowly being forced to reduce their money balances and increase their exposure to risk, and consumers are spending some of the cash they have hoarded, and it all adds up to a virtuous cycle that is giving us a V-shaped recovery. As long as the economy fails to deliver death and destruction, the market finds itself compelled to keep this virtuous cycle going.

After the market rallied strongly into April of this year, a panic attack set in, triggered by the potential for a Greek default that could bring Europe to its knees, and then fueled by intense speculation that the U.S. economy was on the verge of a double-dip recession due to continued weakness in the housing market and consumer deleveraging. This justified the fears of those holding cash, but since the low point in equity prices in early June, we've seen mounting evidence that a recession is far from imminent, and indeed it seems likely that the economy is still growing—at the very least it is clear that there are no signs of "death and destruction." The manufacturing sector is quite healthy; commodity prices are rising, and close to all-time highs; global trade is booming; China and India are not collapsing; unemployment claims are not rising; credit spreads are not soaring, and swap spreads are very low; corporate profits are very strong; the Fed is not about to take any actions that would endanger the markets; Washington is getting closer and closer to extending some or all of the Bush tax cuts.

So we are now in another cycle in which cash proves to be an embarrassment because the economy is not collapsing. The market is now climbing another wall of worry, but on the margin some of those holding cash are trying to reduce their cash balances and increase their exposure to risky assets. Consumers are likely still willing on the margin to spend some portion of the cash balances they began accumulating in late 2008. Confidence is slowly returning. All of this adds up to a virtuous cycle that points to more growth, albeit growth (3-4% being my guesstimate) that will not result in any remarkable decline in the unemployment rate.

The main point is this: when cash yields almost zero, you really need bad things to happen. If they don't, then you are passing up on huge opportunities to profit from, for example, the 8-9% yields on high-yield bonds, and the 7% earnings yield on the S&P 500. The absence of bad news is like a leak in a dike, behind which sits a massive lake of cash and cash-like instruments earning zero. The force of the water (many trillions of dollars) seeping out through the hole in search of higher returns is going to be very difficult to stop and the hole will almost certainly get bigger with time.

There are plenty of reasons to stay bullish on risky assets.

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