In a recent interview with Mohamed El-Erian, former CEO of PIMCO Investments, a most interesting question was posed.
“Q. Where is your money? Stocks? Treasuries? Bonds?
A. It is mostly concentrated in cash. That’s not great, given that it gets eaten up by inflation. But I think most asset prices have been pushed by central banks to very elevated levels.”
His answer sent shockwaves throughout the investment community. How could someone who used to run one of the largest investment firms in the world be in cash? That is just ridiculous, right?
Well, maybe not.
If you read the rest of his answer he makes two very salient points:
1) Being in cash isn’t great given the impact of inflation; and
2) Asset prices are at very elevated levels.
The misunderstanding by the majority of the mainstream media and financial press is that when someone says they are in “cash,” they assume that indiviudal has always been in cash and will always be in cash.
When someone, particularly an individual such as El-Erian who used to manage the Harvard Endowment Fund, suggests they are in cash due to a valuation concern, it does not mean that they will never be invested ever again. It also does not mean that he has always been in cash either and therefore missed the advance in the markets over the last few years.
What it does mean, is that he understands that from current valuation levels forward returns on invested dollars will likely be poor to negative – which means cash will likely outperform to some degree.
The chart below shows the rolling 5-year returns of stocks, bonds and cash on an annual basis from 1928 to present. (Data source is here)
If you look at the chart what you can clearly see is that there are times when cash and bonds have outperformed stocks. This should be quite obvious to those who lived through the “dot.com” crash or the “financial crisis” who now would have gladly chosen “cash” given another opportunity.
But, again, if you listen to the mainstream financial media they will gladly tell you that you are incapable of “timing the market.”
On this point, they are correct. It is impossible to consistently choose the precise tops and bottoms of major market swings. However, that is not what we are discussing. (Read: You Can’t Time The Market?)
El-Erian is making a valuation call. Due to the ongoing Central Bank interventions globally, asset prices and valuations have been inflated to levels that have historically proven to provide very low or negative forward returns on invested capital.
The chart below shows the inflation-adjusted returns of stocks versus cash from 1947 to present. As you can see, there are periods in history where stocks have provided negative rates of return when adjusting for inflation. But cash has also.
However, there is an IMPORTANT difference.
When I own an asset, and it declines in value, I have negatively impacted my investment capital. If I sell at the lows, as most investors ultimately due to their emotional biases, then I have permanently impaired my capital and the ability to generate future returns.
However, when we are discussing “cash” as a holding, we do not suffer an impairment, or loss, of investment capital. We only lose the future purchasing power parity of those dollars during the holding period. With inflation near historic lows, that risk has been somewhat mitigated. However, the loss of future buying power is far different than the actual destruction of investment capital during market reversions.
As I stated, El-Erian is making a valuation call. He is currently mostly in cash as future returns from current valuation levels are likely to be low or negative. While he is losing future purchasing power parity of his dollars today, he has sheltered his investment capital from impairment so that it can purchase investments in the future that will yield a much higher return.
The chart below is an inflation-adjusted model of a portfolio that is 60% stocks, 35% bonds, and 5% cash. (This is the same model that is published in the weekly newsletter.) Since El-Erian is making a valuation argument, I have included the Shiller CAPE Ratio.
Not surprisingly, when valuations have been at current levels or higher, future returns on the portfolio have been low or negative. When it comes to your investment portfolio, and most importantly your time horizon, a mistake can be extremely costly. As I quoted in “Shiller’s CAPE – Is It Really B.S.?:”
Cliff Asness discussed this issue in particular stating:
“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.
If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations.”
Asness continues:
“It [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view the critics have not provided a good reason this time around — I think you are making a mistake.”
What is GROSSLY misstated by the financial media, and misunderstood by investors, is the function of time frames.
Using the portfolio above, I can certainly make the case for buying and holding a portfolio of stocks, bonds and a little cash for the long-term. But here is the problem, how many people do you personally know that started investing in 1947 and are still alive today?
As I wrote in “How Long Is Long Term:”
“Secondly, exactly how much time do individuals really have? While it certainly sounds charming that ‘youngsters’ are throwing their money into the Wall Street casino, the reality is that this is hardly the case. Youngsters rarely have sufficient levels of investible savings to actually invest.
Between starting a career, raising a family and maintaining their specific standard of living there is rarely little remaining to be “saved.” For most, it is not until the late 30’s or early 40’s that individuals are earning enough money to begin to save aggressively for retirement and have enough investible capital to actually make investing work for them after fees, expenses and taxes. Therefore, by the time most achieve a level of income and stability to begin actually saving and investing for retirement – they have, on average, about 40 years of investible time horizon before they expire.”
Given the impact of two very nasty bear markets since the turn of the decade, it is not surprising that a large majority of the population has little or no money invested in the financial markets. It also explains why there are more individuals over the age of 65 still in the labor force rather than enjoying their golden years.
For the average American that is trying to save for their retirement, the destruction of investment capital was far damaging to that goal than the loss of future purchasing power due to the impact of inflation. Given the choice, I imagine that the majority of individuals would choose to have their capital back.
So, while the media pins El-Erian as “crazy” for being in cash; he may just be “crazy like a fox.” I am quite sure that given his personal skill and experience he will be putting that cash back to work at a much more opportune time. The question is whether you will be doing the same, or just hoping that someday you will once again get back to even?
