We keynoted our first blog post on May 31, 2017 with an inauspicious title, An Enterprising Thought: Cash Is an Option. From that point, the S&P 500 continued its seemingly endless advance, finishing the year up 10.8%. In May, the two-year treasury was yielding a middling 2.2%. Ever since the Great Recession, cash has been a dirty word. As a result, money flowed into every other asset class, with equities being the best-performing over the last 10 years.
During 2018, however, the trend has completely reversed. Volatility has returned with a vengeance and the popular indices are down 20-30% from their September/October highs. As if to add insult to injury, that four-letter word asset is now yielding 3.07%. But that’s yesterday, what about tomorrow?
Before addressing that question, here’s what we wrote 19 months ago:
Current investment conventions maintain that cash —or, in my case, a portfolio of laddered short-term U.S. treasuries—is a static holding. That’s a rather unimaginative perspective. Think of it as a call option on any asset, with no expiration date, and with no strike price. The temporary sacrifice of return is merely the price of the option. The result, however, is the ability to seize future bargains—the wellspring of outsized gains—wherever and whenever they might appear. This more expansive view makes the present absence of return much less bothersome.
In this context, an investor’s asset allocation decision is not simply between earning nothing in cash or earning something in bonds or stocks. Instead, it is how much the cash can earn if available when assets that have become cheap, versus the upfront cost of holding it for the current moment.
It is at this point that I part company with most investment firms still buying assets at current prices. Simply put, I don’t see much future opportunity in 10-year Treasury bonds yielding 2.2% or the S&P 500’s dividends yielding 1.97% while selling at a nosebleed price/earnings ratio of 30-times 10-year average earnings. With market overvaluation induced by the current Fed policy and tail risks high, I think the price of the above-described call option is well below its intrinsic value. If that which most investors think improbable, or even impossible, happens (think no farther back than to 2006-2007 for the most recent extraordinary popular delusion – not counting today), the value of cash as a call option will skyrocket. In the irrationality of the moment, investors will sell other assets at absurdly low prices to acquire, of all things, cash!
We are often asked,”what protection does cash give investors against inflation?” Most people assume the question relates to consumer price inflation (CPI), for which the year-over-year average over the last five years has been 1.3%. The answer is, barely. The average yield on the 5-year U.S. Treasury note has been 1.4%, before taxes. The irony is that the well-to-do investor’s well-being would not be threatened by consumer price inflation rates two or three times the current level. Compared to most of the population, he or she spends only a modest portion of income or wealth on consumables, while expending a far greater portion on asset purchases, the prices of which have inflated dramatically in recent years. Nothing will destroy the wealth of the wealthy as fast as deflation in financial and real assets. Only cash protects against that risk. Interestingly, we rarely get the question, “how do I protect my portfolio against asset price deflation?” Ironically, CPI deflation will precipitate or accompany asset price deflation. Cash, the all-purpose hedge, ends up being the perfect asset in both scenarios.
Of course, most investors think they are not getting their money’s worth when they see their investment manager holding large amounts of cash. Some “enterprising” investors may gradually realize instead that they are paying someone who has demonstrated the necessary expertise to buy cash as a call option when it is utterly out-of-favor and thus compellingly cheap, despite the agonizing wait for bargains to appear. Such careful thought and deliberate inaction may chip away at the foundation of the institutional imperative that only sees value creation where there is activity. Enlightened passivity is expected of philosophers, not investment managers.
Nassim Taleb gets to the nub of the matter in his bestseller Antifragile: Things That Gain from Disorder:
It’s much easier to sell “Look what I did for you” than “Look what I avoided for you.” Of course a bonus system based on [short-term] ‘performance’ exacerbates the problem. I’ve looked in history for heroes who became heroes for what they did not do, but it is hard to observe nonaction; I could not easily find any.
“Look what I’ve avoided for you” falls on deaf ears when the auction crowd is bidding up prices to ridiculous heights. During those times it is nonaction—keeping the bidding paddle in one’s pocket—that can become the stuff of which tomorrow’s heroes are made. Self-control, understanding, compassion, patience —and a thick skin—are most of what is required to stay the course. When the noise reaches a crescendo, one can find solace in the old Yiddish proverb: “Provide for the worst; the best can take care of itself.”
Amidst all the clamor, thinking outside the box about the optionality of cash gives quiet but resolute credence to the contention that this seemingly benign asset is in reality a double-edged sword, defending against loss on one hand and arming for gain on the other.
Returning to what is ahead “tomorrow?” In September of 2017 we argued that, in the aggregate, stocks were far from a compelling value proposition. To be sure, the recent accentuated selling is a step in the right direction, but little more. Moreover, the odds are increasing that we are in the early stages of a down cycle. Our strategy to “go long the short side” with a portfolio of out-of-the-money put options has kept us busy while we patiently wait to buy the businesses we’ve long wanted to own at prices that make the investment economically compelling. One of these days we will no longer hold much cash because the purpose for which it was held will no longer exist. Other asset classes, most likely common stocks, will be so attractive that exchanging our cash for them will be a no-brainer. No doubt, we will be in the minority.