Ode to Cash
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Board: IV Value Central
James Montier looks like a middle linebacker and does a brilliant job tackling the difficult question of what provides good tail risk protection in a declining market. Surprisingly he comes down on the side of cash.
Knowing how much cash to hold has always been one of the most difficult parts of managing money [at least for me]. I tend to feel guilty about high levels when markets are going up and then feel stupid for not having more when the markets are crashing.
Since June and the end of QEII, I have been selling some positions—both the overvalued and those that appear to have no potential to live up to my original expectations. Cash has also accumulated from additions. I have done almost no buying during the big run by the S&P to 1360 in May or at what appears to be an endless series of new market lows since August. Volatility has been massive.
During this downturn and in 2008-2009, I kept looking for that perfect investment that would protect my portfolio from these terrible market-wide drops. There are all kinds of tail risk insurance vehicles including ultrashort ETFs, buying the VIX, options/contingent claims, and maybe----cash?
What should an investor use?
Montier begins by trying to define what tail risk coverage should actually cover. Are you insuring against liquidity troubles? Inflation? Deflation?
I suspect most of us are concerned with liquidity. Remember how hard it was to find buyers at good prices for any stock during 2008 and early 2009? There was a distinct lack of liquidity during the height of the panic.
Montier shows us several portfolios and how they perform during a liquidity crisis. As it turns out his optimum portfolio is a 70% long S&P offset by a 30% VIX strategy. This will out-perform at the peak of the crisis. For a graphic look at the graphs exhibit 2 and 3 in the linked paper. Great-- this must be the answer. But things are not that simple for we mere mortals trying to time our way into the optimum time to buy volatility. Most of us can’t.
The time to consider buying insurance is when you are absolutely convinced you will never need it. How great did the market look last spring -— like it was never coming back down? When the good times are rolling, insurance is cheap, but it is at just that point you think you will never have any use for it.
We start wanting insurance when the market is imploding, and by that time, insurance is expensive and may not pay its way as a part of your port.
In recovery our timing has to be equally brilliant with a sell decision at the peak of the crisis, freeing up the cash we need to buy equities at the bottom. The tendency is to want to hang on the outperforming tail risk and wait too long to let go and get cash back in play.
A few key concepts in support of cash
There are three elements to consider that allow value investors to eschew tail risk protection and the difficulties in timing the buying and selling of insurance.
1. Valuation risk
2. Fundamental risk
3. Financial risk
Valuation risk is the avoidance of overpriced assets in favor of looking for the best values when opportunity presents. In order to take advantage of sales an investor must have cash in the account and not have to decide to sell assets into an illiquid market downturn to raise cash or have figure out the timing of selling the tail risk protection [for which you might have overpaid if you are only human]. When you need the cash, have it at hand and keep it ready.
As Seth Klarman notes, “Why should the immediate opportunity set be the only one considered, when tomorrow’s may well be considerably more fertile than today’s?”
Buying during maximum drawdown gives you such an immense margin of safety going forward, if you have chosen the equity carefully, your portfolio has every chance of full recovery and then some from the disaster.
Fundamental risk speaks to the permanent damage to intrinsic value events may inflict. This goes beyond valuation and includes thinking about what sort of tail risk specifically we need to cover. Is it deflation or inflation? If it is one or the other, how does it affect the value of the holdings in our portfolio and how do we minimize it? If we are certain of deflation, then bonds should be a part of the insurance. If it is inflation, cash may help.
From the paper:
As an aside, on inflation and deflation and protecting portfolios, cash once again has benefits. In order to generate optimal portfolios we would need a perfect macroeconomic crystal ball. That is to say, if we knew for certain that deflation was in the future, then bonds would make sense. Conversely, if we knew that inflation was a sure thing, then cash would make sense.
But optimal solutions often aren’t robust. They work under one scenario, which can only be known ex post. When constructing portfolios ex ante, the aim should be robustness, not optimality. Cash is a more robust asset than bonds, inasmuch as it responds better under a wider range of outcomes. Cash also has the pleasant feature that, when starting from a position of disequilibrium (i.e., a level away from fair value), it doesn’t impair your capital as it travels down the road of mean reversion to fair value (unlike most other assets).
Because of its zero duration, cash fares better than bonds in an inflationary environment. (This assumes that central banks seek to raise cash rates in response to inflation – an assumption, admittedly, that may be less valid at the current juncture than ever before.)
Cash is also a pretty good deflation hedge. Obviously, as prices fall, cash gains in real terms. Of course, all else being equal, bonds with a higher duration do better. Take the Japanese example shown in Exhibit 7. Cash does well in the initial stages of the bubble bursting (as per the valuation risk analysis above). In 1995, Japan’s CPI enters deflation (albeit mild) and remains flat for the next decade and a half, give or take. Cash maintains purchasing power in real terms. Of course, bonds do better than cash over this period, but to know that ex ante would require perfect foresight regarding the path of Japanese inflation – something beyond our ken.
Finally we have financial risk. Four words encapsulate the concept –- avoid leverage/ be contrary.
Cash is not all bad and being fully invested 100% all the time is not necessarily desirable.
The wrong time to think about insurance is when the house is burning down. As illogical creatures we are easily lulled and convinced by the here-and-now and crowd behavior. We think the good times will last forever.
Conversely when the markets appear to be dying an ugly death and investors are heading for safer havens and buying insurance, we start crowding into those same investments at any cost. Zero yield treasuries? High-priced ETFs and options?
While cash may under-perform tail risk protection at the apex of a crisis, it is more forgiving of the poor timing buying and selling the insurance is subject to. It also has the “pleasant” feature of giving you something to use to buy the portfolio-saving values when they come without having to make pressured decisions what to sell to raise cash in the heat of the moment.
Let’s hear it for cash.