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Cash will be king again

There is little doubt in my mind that we are closer to the end of a major and long-lived credit cycle than we are to any beginning, writes Roger Montgomery.

Further, there is no ambiguity about the outcome. 

The absence of value in almost every asset class is the reason our funds’ investment processes are overweighted to cash. The Montgomery [Private] Fund, for example, is holding nearly 40 per cent cash. For the time being we will look out of touch compared to our optimistic, and fully invested peers, but after reading this article you should be left in little doubt about whether being fully invested and dancing close to the exit is a wise strategy. 

Cash of course is a horrible investment option offering punitive returns. But those punitive returns are precisely what caused the mass exodus out of cash in the first place. Where once cash was king, it now represents a liability to those holding it. 


Of course that money flowing out of cash accounts had to find a home somewhere. And at first it flowed into property and shares. 

Unsurprisingly, and assisted by some foreign investment, property prices in countries like New Zealand, Australia and Canada smashed all-time records and building activity boomed. The record $26.25 million paid for the Besen family home in Melbourne’s Toorak, as well as the rumoured $20 million for their Mornington Peninsula weekender is reflective of the tidal wave of funds flowing away from cash holdings.

And now, the stock market is having its day in the sun. The Cape/Shiller PE ratio is trading at 30 times earnings — a level only reached or exceeded twice since 1880 — once prior to the tech wreck and once prior to the Great Depression. The US stock market has been in a bull run for almost eight years and currently, the 12-month trailing price-earnings ratio of the S&P 500 is 21.1 times, which is materially higher than the historical average of 16.6 since 1970. 

While we might be more cautious than our peers we could also be a touch early. In the final stages of a boom, extreme overvaluation is often justified on the grounds that growth is improving. The surge in share prices this year has been bolstered by strength in corporate profits. S&P 500 companies reported 12.6 per cent growth in second quarter profits from a year ago, and relative to GDP, profits are much higher than they have been on average since WWII.

Meanwhile we are seeing a concentration of money flowing into shrinking group of listed beneficiaries. Back in the 1960s and 1970s those beneficiaries were the Nifty Fifty stocks, a group of 50 companies listed on the New York Stock Exchange that were considered buy-and-hold blue chips that could do no wrong. And while Disney, McDonalds and General Electric were on the list, so were Xerox, Polaroid, Kodak and Simplicity Pattern.   

These were companies that were not hampered by thoughts of an interrupted or disrupted future because there had been no disruption of their past. History had yet to catch up with them and so, in the eyes of investors, they could do no wrong. But of course by the early 1970s prices reached their zenith and subsequently collapsed.

By mid-May of this year almost 50 per cent of the S&P500’s gain could have been attributed to just 10 stocks and fully one-third has been generated by just five companies – Apple, Facebook, Amazon, Google and Microsoft.

Today, companies like Uber, Twitter and Tesla command the sorts of price premiums that belie the fact they make no money. These companies are like those famed value investor, Howard Marks, recently observed were being bought into an “entirely new future” because they are “untrammelled by knowledge of the past”. 

Here in Australia the P/E ratio is at 18 times, which is 7 per cent above the level reached prior to the GFC. Importantly, in the last five years only 19 per cent of the rise in the P/E can be attributed to growth in forecast earnings, the the other 81 per cent simply reflects investors’ willingness to pay more for the same dollar of earnings.

When risky investments become preferred to low-risk alternatives like cash, record prices aren’t unusual. And when cash earns a punitive return, the fear of missing out replaces the fear of losing money.

After a while, the early investors, in shares and property, have to find somewhere to put their earnings.  With cash still offering low returns the wealthy make their way to the auction houses to buy non-income producing assets such as art, wine collections, low digit number plates and even New Zealand stamps. That’s what happens towards the end of a boom; collectibles prices reach new highs, risk premiums plumb new lows and markets become risky. As Jeremy Grantham at GMO noted, “the market, however, appears not to care at all about the past or to learn much from it.”

The inverse of record high asset prices today is record low prospective returns. In fact, GMO estimated prospective real returns, for various asset classes, for the next seven years, and the very best is offered by emerging market equities, with an estimated return of just 3.8 per cent. The worst was large US equities offering -3.8 per cent.

The problem is this; in many cases alternative assets are offering prospective returns that are as low, or even lower, than cash. But cash has no prospect of capital loss. So, cash now offers the same prospective return as these other assets but it provides much lower risk. Cash is starting to look attractive again on a risk adjusted basis. 

How this all ends, is no mystery, only its date remains to be determined, so at Montgomery we are becoming a little more cautious and circumspect, readying ourselves, with a relatively large balance of cash, to take advantage of bargains.

In the interim we will look like we are out of touch and our returns will continue to lag those of our more optimistic and fully-invested peers. 

But keep in mind, holding cash when nobody else wants any, will give you an asset that is most valuable when nobody else has any.

Roger Montgomery is chairman and chief investment officer at Montgomery Investment Management.

Cash will be king again
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