The Only Certainty: Holding Cash Will Not Be Productive

By: Tom Madell | Thu, Apr 2, 2009
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In my last Safe Haven article, I talked about investors' desire to find information that will enable them to correctly decide what to do now, if anything, about their stock fund investments. Should one increase or decrease them, or just stay on hold?

When looking out over the next 6 months or less, is there anything that can reliably tell us if the stock market is near (or already past) a bottom, or should one wait if they have money they would like to invest? In other words, can anyone using all of the data we have available ascertain whether the market is headed up or down over the next 6 months?

In that article, I concluded that no matter how hard we try to forecast, including studying the words of knowledgeable market, economic, and government experts, it is just about impossible to determine the market's near term direction any better than flipping a coin. As hard a pill as this is to swallow, we must if we are to be able to basically ignore the short term and continue to make sound long-term investment decisions. The same likely applies to making decisions about where the overall bond market is headed over the next 6 months or so.

While nothing then can reliably help us to answer the above questions, there is one thing that is totally certain, or 99.5% so. At least in terms of absolute returns, I can see almost no positive outcome as a result of holding significant amounts of cash within our current investment environment.

Normally, it can make sense to hold cash if no other investment appears to offer the prospect of better returns, or as a possible form of diversification. Of course, you may hold some cash for other reasons, such as to have a guaranteed source in the event of job loss or another extreme event which can be tapped without the need to cash out of stock or bond funds if prices happen to be low. Or, you can hold cash, not because you think it is a good investment, but because you plan to use it to fund future purchases of stocks or bonds when the time seems more appropriate.

As you may have already noticed, the returns available on cash have been falling rapidly. They have now reached levels that, to my way of thinking, make them entirely unacceptable as an investment option. For example, one of the highest paying money market (MM) funds available, Vanguard Prime, currently pays only 0.73% (per year)! If you think that's bad, just wait and see what will happen soon. Since the Fed Funds rate is now at 0 to 0.25%, you can likely expect that money market rates will drop closer to that range over the next few months. And if you hold your liquid funds in a state-specific MM fund, such as for example, the Vanguard California MM, the current rate is a mere 0.47%.

If you reason that at least you are getting a positive return, as opposed to the negative returns possible in the stock market, you need to take into account any taxes due on the MM fund, and, more importantly, the current rate of inflation. Assuming even a low 1% inflation rate over the next year, your MM fund will actually be losing purchasing power. And CD rates are hardly any different - for example, Fidelity Investments CDs are currently offered at 1.20% for a 12 mo. CD. That yield is just about zero after taking into account likely inflation and taxes.

You may not realize it but one of the reasons short-term interest rates are currently so low is part of a deliberate strategy by the Fed to persuade all of us to take on riskier investments. To help resolve the housing and banking crises, mortgage rates need to be as low as possible to induce enough potential home buyers back into the market. This will put a floor under falling home prices. As ordinary citizens get dissatified with the return on MM funds and CDs, the Fed hopes they will turn to higher yielding investments such as bonds (not to mention stocks). When this happens, the hope is that the resulting drop in bond yields (as higher demand causes a drop in yields) will also pull down mortgage rates, which key off of other bonds. And banks are able to be more profitable (or, more aptly, stay solvent in today's environment) when they can borrow money at extremely low rates and lend it out and higher rates.

So, just as when George W. Bush urged people to shop after 9/11 to keep the economy going, the Fed is somewhat more subtlely trying to influence our behavior. To invest in somewhat riskier assets will presumably help the economy to recover. But aside from doing something "patriotic," you will, in my opinion, be helping yourself if you currently have excess money in cash by considering putting it to better use in other types of investments. While no non-cash investment is without at least some risk, if you are able to take a long-term perspective, it seems highly implausible that you will not do better than by merely holding a bundle of cash.

Several categories of bond funds should be able to easily beat cash over the next 6 to 12 months. Please click on the following link to read more about which specific ones I recommend in my April Newsletter.

While stock funds will always subject you to higher risk, consider this:

By merely buying and holding a fund (or ETF) emulating the S&P 500 Index, you will considerably outperform the average money market fund, even if the Index goes nowhere over the next year. When you consider that the Vanguard 500 Index is paying over 3.15%, this should be approximately the return you will receive if the fund is able to stabilize and hold its own. Right now, despite all the volatility, this fund is about at the same price as it was in Oct. 2008, that is, over 5 months ago.

Naturally, one doesn't normally invest in stocks just to get the dividends, but right now, one is being paid to "ride out the bear market" at dividend rates that are only taxed at a maximum of 15% (so called "qualified dividends") vs. up to 35% for dividends from MM funds ("ordinary income"). So, if you are a long-term investor who expects the market to, at a minimum, level out, and even better, go higher as the years pass, you will earn considerably more returns by being in one of these "safer than most" S&P 500 funds. This will be true even if you are too early in making the switch out of cash.

In fact, extremely poor performing 5 year periods for stocks are reliably associated with good subsequent 5 year performance (and even more so for poor 10 year periods as we are in now). Further, it has been repeatedly shown that when the investing public as well as investing professionals become extremely negative about stocks, a condition we certainly have today, such occasions are usually a good time to increase your exposure, and, of course, vice versa for times when most people feel extremely positive about stocks.



Tom Madell

Author: Tom Madell

Tom Madell, Ph.D.
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