Investors Sitting on the Sidelines
BlackRock concluded that 35% of affluent investors’ assets are sitting in cash and savings accounts.
A mountain of cash
A separate survey from UBS stated a modestly lower number of 28%1 . Either way, when compared to the norm (about 5% of a portfolio allocated to cash), these high percentages illustrate a mood of heightened anxiety that has produced a willingness on the part of investors to hold cash instruments that yield almost no return. The markets are in uncharted waters and many have chosen to “”sail with caution””.
To help put these numbers in context, consider this figure from the U.S. Federal Reserve: U.S. investors have some $10.8 trillion sitting in cash and cash-like investments. That’s a big number – roughly two thirds of U.S. Gross Domestic Product (GDP). This mountain of cash has given rise to the phrase, “there is a lot of cash on the sidelines”, an expression which is being bandied about on Wall Street, Bay Street and in the financial media to describe the phenomenon of investors seeking safety in cash rather than investing in stocks, bonds or other investments.
While we are strong believers in the idea that holding some cash provides valuable “optionality” (meaning that keeping cash on hand today affords you the option to buy when bargains become available tomorrow), today’s elevated cash levels are intriguing and warrant further discussion.
What does “the sidelines” mean? And What does it mean for markets?
Not everyone agrees as to just what “cash on the sidelines” really means. In an amusing and insightful article entitled “My Top 10 Peeves”, Cliff Asness of AQR Capital Management takes exception to the loose use of the phrase:
Every time someone says, “There is a lot of cash on the sidelines,” a tiny part of my soul dies. There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines².
If this popular phrase simply isn’t true and cash can’t, in fact, move on and off the sidelines, does it really matter that investors are holding high levels of cash? In a word, yes, and one of the main consequences could be higher future equity prices. Over time, as more investors decide that they want to reduce their cash holdings and get back into the markets, the demand for stocks will rise while the supply of stocks will stay more or less the same, exerting upward pressure on stock prices.
Using a simple example, imagine what would happen to the price of a coveted ticket to the Olympic gold medal hockey game if fans who had been waiting to buy suddenly came out in droves. The seller would increase the price of the ticket in response to that demand and sell to the highest bidder. For equity markets, a similar dynamic is likely to play out when investors begin to collectively show a greater appetite for investing in equities – the amount of cash won’t change but the demand for scarce assets (stocks) will increase.
A whole lotta nuthin’
Putting aside the debate on the validity of the phrase “cash on the sidelines” for the moment, let’s just focus on the fact that investors are holding an awful lot of cash. So, what are investors earning on this cash that is sitting on the proverbial sidelines?
For Canadians the answer is, unfortunately, next to nothing or, more specifically, about 0.78%3 .
While returns on cash for Canadians have been paltry, the issue is even more acute in the U.S. market. We can see from the chart below that the amount a U.S. investor earned in 2013 on US$100,000 invested in 6-month certificates of deposit was an appalling US$270 (yes, you read that correctly). In 2006, prior to the financial crisis, that same investment would have generated US$5,240 of income per year4.
In addition to the slim returns investors can earn in cash instruments, bond investors are also facing much lower income streams than were available historically — again due to the low level of interest rates. That subject was covered in our last edition of Nexus Notes, so we won’t go into it any further here, but suffice it to say that investors are facing the very real prospect of interest rates that are “lower for longer” and correspondingly low income streams.
In the long term, it’s tough to win the game from the sidelines
So, what are individual investors to do? Over the long term, most individuals simply cannot fund their retirements by maintaining such high allocations to low yielding cash and bonds. Nor should they engage in speculative market timing, entering and exiting the markets according to the news of the day. In some respects, the current focus on whether an investor is on or off the sidelines is reminiscent of exactly that: a debate over when is the right time to jump in or out of the market. Respected value investor Seth Klarman eloquently dismisses that strategy with this statement: “In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking”5. Rather, what each investor needs is a financial plan containing strategies to achieve their long-term goals. Although it’s never easy, it is important to ignore the noise of the market and concentrate on the ingredients for long-term success:
- Invest in high quality businesses…
- …and buy those businesses at good prices
- Intelligently diversify your portfolio
- Manage risk
- Apply a strategic asset allocation mix that addresses your specific needs
- Try to keep your emotions in check and stick to the plan
The swing may have already started
One of the most dependable patterns in the financial markets is the pendulum of human emotion that swings from extremes of fear and risk aversion to extremes of greed and optimism. As we pointed out earlier, today’s investment climate is marked by a significant amount of investor anxiety, with the result that investors have been happy to hold cash that yields next to nothing.
As residual fear from the financial crisis fades and the pendulum swings back towards optimism, we expect investors will collectively attempt to reduce their cash holdings and rotate back towards equities. As this happens, the dynamics described above should increase demand for stocks and provide a tailwind for equity prices. Indeed, judging by the remarkable rise in markets in 2013, it can be argued with some conviction that this process may have already begun.
1 “Cash is Still King for Affluent Investors.” Financial Times. December 6, 2013.
2 Clifford S. Asness, “My Top 10 Peeves.” Financial Analysts Journal Vol 70 (2014).
3 In 2013 Canadian investors received an average rate of 0.78% on 1-year GICs.
4 In 2013 U.S. investors received an average rate of 0.27% on 6-month negotiable certificates of deposit. This compares to an average rate of about 6% during the period 1964 to 2012.
5 Klarman, Seth. “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” (1991).