Ray Dalio (Trades, Portfolio), the billionaire hedge fund manager, famously claimed "cash is trash" in January. At the time, Covid-19 was not classified as a pandemic by the World Health Organization, and many expected the spread of the virus to be contained in China.
Since then, the United States has become the epicenter of the virus, and according to the Bloomberg recession prediction model, an economic downturn is now unavoidable.
U.S. equity markets have declined drastically since reaching record highs in February. For instance, the S&P 500 Index is down approximately 15% year to date as of April 13, even after the gains in the last week.
Investors with access to cash, undoubtedly, are in a better position to bank on the attractive opportunities that have surfaced as a result of this decline. Regardless, Dalio still holds that it’s unwise to hoard cash. This analysis attempts to determine the thought process of the guru based on his recent comments.
Volatility and negative returns are two different concepts
Dalio has been proactive on social media platforms such as LinkedIn and Reddit since the outbreak of the novel coronavirus. Answering a question by a Reddit user, the guru wrote:
“Please remember that while it (value of cash) doesn’t move around in value as much as other assets, there is a costly negative return to it. So I still think that cash is trash relative to other alternatives, particularly those that will retain their value or increase their value during reflationary periods (such as gold and some stocks).”
The primary objective of an investor should be to generate attractive returns in the long term. To do this, it’s imperative to invest in asset classes that will produce the best returns. Cash, however, fails to deliver market-beating returns in the long term. When there is significant volatility in markets, many investors are quick to lose their perspective and seek the shelter of safe-haven asset classes such as cash and bonds. In the short-term, such a flight to safety proves to be a wise decision as stock prices tumble across the board. However, things look drastically different when the long-run investment returns of various asset classes are evaluated.
Source: Novel Investor
Data from the above table confirms that cash is the worst-performing asset class over the last 15 years. But, in 2018, when capital markets delivered negative returns as a result of trade tensions between the United States and China, cash delivered the best returns in comparison to all other types of securities. This, however, is not an accurate representation of historical performance.
As Dalio points out, short-termism is dictating the terms of the investment decision making process of many investors today, which could prove to be a costly mistake (unless, of course, you need liquiditity).
Now is the worst time to be hoarding cash
Tactically allocating a small portion of a portfolio to cash and liquid assets has proven to be a wise decision. The ideal number varies from one investor to another because of differences in the investment time horizon, near-term financial obligations and the level of risk tolerance.
“Berkshire will always maintain supreme financial strength, operating with at least $20 billion of cash equivalents and never incurring material amounts of short-term obligations.”
Hoarding cash, however, is a different concept altogether, where an investor holds on to liquid assets in fear of a decline in stock and bond prices.
As recently as February, the Shiller price-earnings ratio was above 30, in comparison to a historical mean of just 17. However, the recent market rout has resulted in a partial convergence with the mean, which is a positive sign for investors and an indication that the market is not as overvalued as it used to be.
There is a possibility of a continued fall in stock prices, but according to Dalio, investors need to remind themselves that there’s no methodology to pinpoint the inflection point when stocks would start appreciating. Therefore, now would be a good time to utilize excess liquidity by investing in undervalued stocks.
“I never have an opinion about the market because it wouldn’t be any good and it might interfere with the opinions we have that are good. If we are right about a business, if we think a business is attractive, it would be very foolish for us to not take action on that because we thought something about what the market was going to do. If you’re right about the businesses, you’ll end up doing fine.”
This is timely advice for investors who are waiting on the sidelines for better opportunities even after identifying attractive companies to invest in. For instance, it’s a no-brainer that many leading energy companies will survive the current turmoil. According to the estimates of the U.S. Energy Information Administration, the price of a barrel of crude oil will soar to over $100 by 2040, driven by a surge in demand resulting from industrialization in emerging markets. However, there is uncertainty about the short-term outlook, which is preventing investors from banking on the opportunity to invest in oil giants such as Exxon Mobil Corporation (XOM, Financial) at five-year low earnings multiples.
In my opinion, financial services companies are also not receiving the attention they deserve. According to GuruFocus data, this sector is trading at an average price-earnings ratio of 8.43, which is the lowest level reported since the financial crisis of 2008. Back then, banks had poor balance sheets and liquidity was questionable. On March 11, Bank of America CEO Brian Moynihan said:
“The chief executives of the large banks here want you to know that because of all the work done on capital, liquidity, and all the other things, we are in a sound position. As we look forward to uncertainty due to the virus and oil price changes, we are very strongly capitalized. We are in a great position, in terms of liquidity, capital, and strength.”
Regional banks might find it difficult to grow operating income as a result of near-zero interest rates. However, major players in the industry have well-diversified revenue sources.
In the long run, policy rates will most likely rise along with the expected inflation. As depicted in the below chart, this is exactly what has happened in previous economic downturns.
Source: Inflation Data
According to historical data, it would not be prudent to assume that inflation will remain below the Fed target rate of 2% for a prolonged time. After the measures put in place in response to the 2008 financial crisis, a bet against the big banks is now a bet against the American economy, as the fortunes of this industry are closely tied to the economic growth of the country.
Takeaway: cash will not generate attractive returns
Dalio's “cash is trash” claim attracted criticism when the markets entered a downward spiral. However, the guru is not focused on the short term, and his advice should be evaluated from a long-term perspective. Cash, as an asset class, will not improve the performance of a portfolio. Rather, tactical allocations to liquid assets should be converted into investments in stocks and bonds when attractive opportunities are available. Despite the volatility associated with equity securities today, I agree with Dalio that the best course of action is not to hoard cash, but to invest in undervalued companies with strong balance sheets regardless of the economic environment.
Disclosure: I do not own any shares mentioned in this article.
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