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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-weekly Asset Allocation Report for December 9, 2024. I'm Phil Adler. It does make sense that when you look at the world of investing, the total world of investing, that a high amount of cash held in money market funds might subtract from total assets invested in stocks, and stock valuations might shrink as a result. But clearly that equation has not been working lately. Confluence advisory director Bill O'Grady joins us today to discuss what this might portend for the stock market.
Phil Adler:Bill, what is the history of this relationship between stock market performance and the level of cash held in money market funds?
Bill O'Grady:Well, the theory works like this. Households have a certain level of cash they view as a minimum. This is the idea of cautionary balances or rainy day money. Beyond that level is money that could be used for additional spending or for investing. What we have found is that since the great financial crisis, the minimum in retail money market funds seems to be around $920,000,000,000 When money market funds fall to that level, equities tend to stall.
Bill O'Grady:On the other hand, when levels are above that and decline, it is often a situation that shows retail money market funds are going into equities. We saw that especially when the equity market bottomed in March of 2009.
Phil Adler:Is what's happening now an anomaly?
Bill O'Grady:It is. What we're seeing now is both rising cash levels with rising equity market. Essentially, the markets are awash in liquidity.
Phil Adler:So what explains this recent activity? Why has the S & P 500 been rising even with money market levels remaining high?
Bill O'Grady:Well, I suspect 3 events are happening. 1st, high levels of employment are fostering 401 k funds into equities. These investments are usually passive in nature. When workers put money into retirement each month, it's a non price sensitive buyer of equities. 2nd, we are seeing the second order effects of the pandemic fiscal support.
Bill O'Grady:The initial funding to households was means tested, meaning that the money went to less affluent households. But as they spent down their savings, their money went to companies who are owned by the top income brackets. Some of this money made it into money market holdings of the wealthy in the form of dividends. 3rd, after nearly a decade of close to 0% yields on cash, the recent Fed tightening cycle has lifted money market yields to around 5%. At long last, cash has returned as an asset class, and a fair number of investors are content to hold cash because the opportunity cost of owning other financial instruments has declined.
Bill O'Grady:But the bottom line in all this is that the government created a massive flow of liquidity to the economy and it hasn't taken it away.
Phil Adler:In other words, it seems there's plenty of money available to support both stocks and invest in money markets, And liquidity is ample.
Bill O'Grady:It is.
Phil Adler:Well, it makes sense that higher income investors have the most to invest in stocks. Is the higher income segment of our population doing particularly well compared to everyone else and simply can't spend all the money they have, so they invest it. And this is what fuels both stocks and money market funds.
Bill O'Grady:In breaking down the asset allocation by income decile, only the top 20% persistently has equities as their largest allocation. The 60 to 80 has equities or real estate trading off over time. The bottom 60% consistently have real estate as their largest asset allocation. Although the top 20% spend the most money, they still have the excess liquidity available, and their behavior is what drives financial asset markets.
Phil Adler:So, Bill, can we conclude that income inequality in the United States is growing and the result is good for the stock market?
Bill O'Grady:It is not the only factor boosting equity markets, but putting more liquidity into wealthy households create conditions for rising equity values.
Phil Adler:Does this signal more growth is possible for stocks even if valuations are high?
Bill O'Grady:Well, it does with a caveat. This liquidity can go other places as well. Tracy Alloway, who's the cohost of the Odd Lots podcast, often refers to this excess savings as a large ball of money, and the job of strategists is to figure out where it's going to roll next.
Phil Adler:Can stocks continue to advance if the Fed decides to pause future interest rate cuts?
Bill O'Grady:They can, although the pace might be slow. Investors might simply hold high levels of cash since the opportunity cost will be less for doing so.
Phil Adler:Bill, a lot of people pay attention to how Berkshire Hathaway invests. It appears right now that the Berkshire cash reserves are very high at the same time that shares in Berkshire Hathaway Hathaway are beating S & P 500 returns. Is the Berkshire strategy and the result of that strategy perhaps a microcosm for stock market performance as a whole?
Bill O'Grady:Well, Phil, that's an interesting observation. Buffett is a renowned value investor. I suspect his high cash levels reflect more that he thinks everything he's looking at in the equity world is excessively valued. This is one of the issues I've been studying for the past few years. We don't have time to dive deeply into this concept, but if we think of money having 3 functions, mainly a medium of exchange, a store of value, and a unit account, we should note that the first two of these can be in contradiction.
Bill O'Grady:If we ensure there is ample medium exchange, it can degrade the store of value function. Central banks have historically tried to balance these contradictions, creating enough cash to keep the economy going, but not so much as to create higher inflation as to undermine money's store of value. But over the past 4 decades, technology has led to greater financialization of markets. What this means in practice is that the wall between assets and cash has become thinner. Here are two quick examples.
Bill O'Grady:It used to be that taking out a second mortgage was a sign of financial distress. Thus, as homeowners built equity by amortizing their mortgages, that value was locked up until the owners sold the house or died. But with refinancing, a home became a source of liquidity. In equities, it used to be the commissions were high. The price spread on stocks was a minimum of 12 and a half cents, and a stock would take 5 days to clear before the liquidity would be available.
Bill O'Grady:Now there are no commissions. Spreads have narrowed dramatically, and you get your cash the next day. In other words, the liquidity penalty for converting cash to stocks has declined. As this wall of assets and liquidity thin, we can reconcile the store of value in medium exchange function. In other words, we can hold assets to protect our purchasing power and liquidate them easily to gain medium exchange.
Bill O'Grady:Where this became very evident recently was Turkey. Although the Turkish economy was dealing with horrific inflation of around 80% a year, the equity market actually outperformed inflation. I don't think Turkish households were buying stocks because of their value, but because they were protecting their purchasing power. It's not the valuation doesn't matter, but in our current environment, it perhaps matters less because we're using assets as a form of cash holdings.
Phil Adler:Bill, how does Confluence view cash right now? Do you acknowledge cash in your models?
Bill O'Grady:We do, although it's mostly a placeholder to facilitate trades and a place for dividends to go until they are invested. But for our views on cash, one should look at our holdings of cash plus short term fixed income. The latter is near cash, and it shows ideas about the ideal level of cash in a portfolio.
Phil Adler:Thank you, Bill. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.