Fear stronger than bubbles

11 Dec 2013 90 month(s) ago

fearThere are concerns that the American stock market is overheating and bubbles are beginning to form in the world economy. But fear remains the overriding sentiment, and investors are still parking much of their capital in cash, despite low interest rates.

fearThere is much talk about the high valuations of the US stock market. If there is a correction, it will have an adverse effect on the Australian market. But these are not usual investment conditions. For one thing, interest rates have rarely been lower, which takes a lot of pressure of companies, both in terms of how they are assessed as investments compared with fixed interest, and the borrowing pressure that is on them.

This point was made in The Economist, which, when it senses that a bubble is forming, has a practice of calling for interest rates to be increased. But this time it is different, because the global financial system is still recovering from the GFC:

"The S&P 500 share index is up nearly 30% this year, even as America’s recovery has been lacklustre. Measured against an historic average of profits, its price-earnings ratio, at 25, is well above its historical norm (around 16.5). Ordinary folk are not yet piling into shares, but sophisticated investors are once again using big dollops of debt to spice up returns.

As before, central bankers are fuelling the asset-price surge. Having cut short-term interest rates to zero, they are trying to bolster enfeebled economies with unconventional tools such as “quantitative easing” (printing money to buy bonds) and by promising to keep rates low for a long time. The largesse is unprecedented, and is lasting longer than anyone expected.

But this time it is the right thing to do. Higher rates would fell the rich world’s still-enfeebled economies and risk a dangerous deflation. Instead of tightening, policymakers should work harder to ensure that cheap money translates into new investment rather than higher prices for existing assets."

Bubbles are becoming much more a part of the investment landscape, as this graph shows:


Bubbles happen more frequently, but the recovery tends to be faster. Even the GFC has been patched up reasonably quickly given how cataclysmic it was (and nearly fatal for the whole system). One of the peculiarities of the GFC is how well it was picked by non-financial firms in the US, who cashed up and are now benefitting from low borrowing costs. While share prices in the US may be high in terms of revenue and profits (the price earnings ratio) the balance sheets of American corporates (and most big Australian public companies) tend to be low in debt, which makes the investment low risk.

Not only are companies cashed up, so are investors. Here is an analysis of the cash situation of investors from Bloomberg. This is hardly an indication of investor mania. Rather, risk aversion is the order of the day. Investors are parking their money in cash because they fear losing it:

"Despite a plethora of bubble talk, chatter about high cyclically adjusted price-earnings valuations and market tops, investors have been carrying an awful lot of cash. This is not a new phenomenon, but rather, has been a persistent condition since this most hated rally in Wall Street history began.

Before we proceed with the details, let me warn you what this column is not: It is not a “Cash on the Sidelines” argument. As we have discussed previously, there is ALWAYS cash on the sidelines. It is a lagging, not a leading, indicator. When an investor buys an asset, it means the other side of the trade sells that asset. The cash merely transfers from one account to another. I don’t garner much insight from sideline cash until it reaches extreme deviations from historical means in individual investor allocations.

Regardless, it has not escaped my notice that a variety of surveys from major firms has revealed a lot of investment dollars is sitting in cash. U.S. Trust, BlackRock, UBS and American Express have all made similar discoveries, especially among high net worth/high income investors. What makes this so significant is the psychological component.

How can we have a stock bubble -- irrational exuberance, animal spirits, whatever -- when the biggest, most affluent investors are so scared they are sitting in that much cash?

And we are talking about A LOT of cash:

American Express found in 2012 that affluent Americans (at least $100,000 in disposable income) had at least $6 trillion in cash savings; they estimate this number “could balloon to $12 trillion by 2014.”

• U.S. Trust: Annual "Insights on Wealth and Worth" survey (respondents have assets of $3 million or more, with 33 percent worth more than $10 million). Of this group, 56 percent said they have “substantial amounts of funds in cash accounts.” Even more millennials (69 percent) do than baby boomers (52 percent).

• BlackRock found 56 percent of affluent investors have "substantial" amounts of cash, with 35 percent of their assets in cash or savings accounts. Perhaps more surprising is that 32 percent of affluent investors globally expect to increase cash positions and savings account deposits over the next 12 months, versus 17 percent who expect to reduce cash.

• UBS Wealth Management noted that 28 percent of client assets remained in cash in Q3 this year. That is “barely less than the 31 percent reported at the end of 2011, when the eurozone crisis was near its fiercest,” according to the Financial Times.

Risk aversion remains a factor. The FT noted that 49 percent of global affluent investors “did not want to take any risk with their money.” This risk aversion was lowest amongst affluent Americans (34 percent), highest among the French and Italians (64 and 59 percent, respectively). Perhaps this helps to explain the relative performances of the S&P 500 versus the CAC 40 and the IBEX 35.

Note that it is not just the wealthy who are hoarding cash. Those with an annual income of less than $45,000 are sitting in approximately 60 percent cash, according to this BlackRock survey. To be accurate, this group has been under considerable economic pressure the past few years. A recent poll found American households use “49 percent of their take-home pay to cover bills, debt and living expenses,” far above the global average of 40 percent. One would have to assume debt is part of the reason they do not have substantial non-cash investments.

I have not found persuasive the argument that cash on the sidelines was bullish -- except when it reaches extremes in individual investor asset allocations (The American Association of Individual Investors does a nice job tracking this). However, these substantial amounts of held cash, according to multiple surveys, make me further doubt the claims of an equity bubble. The psychology of a frenzy does not appear to be present -- yet.

After many years of equity outflows, accompanied by enormous inflows into fixed income, we have only this year begun to see inflows back to stocks. And, this condition could potentially continue for many years."