Cash is king

By A.D. | LOS ANGELES

IF YESTERDAY'S market rout is anything to go by, investors seem finally to be taking the full measure of the panoply of risks and the exceptional uncertainty they face. What are their options in the current context?

Gold, perhaps the oldest refuge of nervous money, has attracted enormous interest from investors who have been rattled by the financial crisis. As of Thursday, gold's annualized real return over the past five years is a stunning 18.3%. That rise has pushed gold into bubble territory, diminishing its claim to safe haven status; putting money into a bubble is hardly a prescription for capital preservation.

The yellow metal is even overpriced against our second candidate, the Swiss franc—despite the fact that the franc itself also looks overheated, as Buttonwood remarked last month. On Wednesday, the Swiss National Bank, which is not prone to hyperbole, called its currency “massively overvalued” and promptly cut the target range for its key policy rate to 0.00-0.25%. The franc has appreciated by close to 40% against the euro since January 2010.

Finally, Treasuries are a reflexive choice in a crisis. Sure enough, the 10-year yield fell by roughly 20 basis points yesterday (yield is inversely related to bond prices), but locking in a 2.40% nominal yield is more akin to surrender than a genuine defensive strategy. Naturally, you can sell the bonds before they mature, but that leaves you exposed to price risk.

In the flight to safety, however, investors are overlooking one asset class: cash. Not all investors, mind you. The Quantum Endowment Fund—George Soros's vehicle—is reportedly 75% in cash. At FPA Capital, Robert Rodriguez, a respected value investor and one of the few people to anticipate the credit crisis, has over 30% of his flagship fund in cash. And in an interview published on July 23rd, the head of PIMCO, Mohamed El-Erian told Barron's:

And don't underestimate the value of cash; in a volatile world both good and bad assets are impacted, and the higher the probability of being able to buy good assets at really cheap levels. You don't want to be fully invested today.

In the Pimco Global Multi-Asset Fund [ticker: PGAIX], which I manage with Vineer Bhansali and Curtis Mewbourne, we have 10% cash, which is very significant.

As Mr El-Erian suggests, cash has a characteristic that is often overlooked: its optionality. Having cash on hand in a volatile market gives you the flexibility to purchase assets in the future at discounted prices. It's a mistake to feel compelled to be fully invested in an environment in which there are few attractive opportunities. Or as hedge-fund manager Seth Klarman puts it: "Why should the immediate opportunity set be the only one considered, when tomorrow's may well be considerably more fertile than today's?" During periods of significant dislocation, when other investors are forced to liquidate positions, cash's embedded option becomes particularly valuable.

The best measures of long-term value—the q ratio and the cyclically-adjusted price-to-earnings ratio—both suggest American stocks are overvalued, even after the recent price declines. What if those discounted prices never materialise? It's true that markets can remain expensive for long periods before value re-asserts itself, but the numerous risks in today's environment are potential catalysts for that process to occur. When it does, prices typically overshoot on the downside along the way, at which point buying opportunities—and those investors with the cash on hand to scoop them up—will both be flush.