Saturday, July 18, 2009

Where Will Investors Invest Their Cash?

If the Economic Cycle Research Institute is correct in their assessment that the recession is over as I noted in yesterday's post, then where will investors deploy their cash position? Money market cash as a percentage of total stock market capitalization stands at nearly 40%. The average cash level prior to the financial crisis was 16%.

From an allocation perspective, investors appear to be under invested in equities. At a minimum the high cash levels may provide support for equity prices or even provide a source of funds that pushes equity prices higher. The below chart represents individual investor allocations as reported by the American Association of Individual Investors in their monthly asset allocation survey.

If one is a contrarian investing in the underperforming asset class can lead to higher returns. This decade that asset class has been large cap equities as measured by the S&P 500 Index, at least compared to bonds.

The potential headwind for bonds is higher interest that may result from the Federal Reserve increasing the Fed Funds rate as well as potential inflation due to the level of monetary support provided by the U.S. Government. The Argus Leading Fed Funds Index reported its second consecutive monthly gain in June.

Argus notes:
In June, the ALFFI climbed five points to 52.45 from 47.48 in May — which itself was a 10 point+ increase from April. This is the highest reading since last October (when we saw 63.15). Four of the six ALFFI’s components registered gains last month, with the core intermediate producer price index and the CRB posting declines. This index is designed to predict changes in the direction of the Federal Reserve’s target rate. It certainly seems as if the next move will be to the upside.
With interest rates at this level, a move higher is more probable than a move lower. Higher rates would push bond prices lower, thus resulting in potentially negative total returns.


狂猪 said...

Hi David,

Within the S&P 500 Index, which sectors typically out performs the market during a recovery?

David Templeton, CFA said...

This is a loaded question and my answer is worth what you are paying. :) Nonetheless, historically, the sectors that lead early in an economic recovery are materials, technology and consumer discretionary. As fate would have it, these are the best performing sectors in the S&P 500 on a year to date basis. The stock market does tend to lead the economic cycle.

Sector Performance

A chart showing the rotation of the sectors during the economic cycle can be found below:

Sector Rotation

Lastly, what is important during this cycle is to have some feel around the type of growth the economy will achieve. Is a large part of the growth going to be driven by non U.S. growth in foreign markets? If so, one might want to tilt their U.S. portfolio toward multinational companies. Additionally, if growth is going to be slower due to slow GDP growth, companies that are consistent earnings growers will likely out perform versus say high beta stocks. That opposite will be true if the economic growth is red hot. High beta stocks will then outperform.

Anonymous said...

Much of the institutional cash is parked with the Fed since the Fed is now paying interest on excess reserves. Reserve balances held with FRB has gone from 0 to 800 billion this year.

David Templeton, CFA said...

According to the Investment Company Institute, assets in money market funds total $3.647 trillion as of July 15, 2009.

Money Market Mutual Fund Assets

The full cap total market value for the Wilshire 5000 Index equals $10.79 trillion as of June 30, 2009 according to Wilshire Associates

This provides a cash percentage of about 34%. This may include cash at the Fed but, if so, that particular cash would be controlled by investors and not the bank per se.

As a result,I believe there remains sufficiently high cash levels that could provide support for equities assuming the cash is used by investors to increase their equity allocation.