Zero — The New Black

October 2, 2009

Recently, fund investors have abandoned money market funds and similar near-zero interest investments, like short-term government bonds, in search of higher returns. Of course, being overly cautious is usually a bad idea. But trying to capitalize on irrationally high returns on higher-risk investments while eschewing safer investments isn't very smart, either.

We hate low returns as much as the next guy, but we like following the fund investing herd even less. We're also not keen on doing what the government tells us to do without at least first considering the alternatives.

After all, the government created low interest rates on short-term investments. It even lowered long-term rates by buying up mortgage and treasury debt with Federal Reserve play money. Ideally, lower rates should result in lower debt payments and increased borrowing, which is good for the economy (although the flipside is the economic drag that lower rates have on those surviving on fixed income portfolios filled with safe investments).

But lower interest rates also create an incentive to speculate. In a turbulent market, investors crave safety. Investors are also cyclical. They invest more when the market is in a boom period, and less during a bust. We believe the government lowers rates in order to counter this cyclical trend and punish the safety seekers. It's the government's way of trying to stop the snowball in its tracks. Far fewer investors would venture back into stocks and higher-risk bonds if they could earn 3-5% risk-free on short-term investments.

During the week of January 7th and March 11th of this year, individual investors held a record $1.37 trillion in retail class money market funds. The week of March 11th saw this year's market low — so far. The graph below demonstrates the inverse relationship between stock prices and money market fund popularity since January 2008. The cheaper stocks get, the more investors hoard their cash.

This inverse relationship kicked into overdrive around May 2009, when economic recovery first appeared attainable. Fund investors have pulled out nearly 20% of the money they held in money markets, and piled it into stocks and higher-risk debt. Some funds probably went into CDs, but the bulk went to higher-risk assets.

Total money market fund assets, including institutional class money market funds (high minimum and limited access), followed a similar pattern, and peaked at about $3.9 trillion around the same time. Today, that figure is down to approximately $3.4 trillion. That’s half a trillion dollars going back into higher-risk assets in just a few months. No wonder stocks and junk bonds are up.

We don’t know how long this trend will continue – probably just until the next scare in the market. Money market assets can only go so low, because as much as $2 trillion of the total will never find its way into stocks, regardless of market environment. 

We generally like to add to lower-risk investments when others are cutting back, and vice versa. You may remember that we made our last major buy into higher-risk assets when money market assets were at their peak. Needless to say, if this money market total asset line continues downward, we'll begin buying where others are selling.

But how could we even consider a near-zero-return investment?

First of all, cash doesn’t really yield zero today. Image a fund yielding 0.50%. Inflation has been slightly negative over the last year- negative 1.5% a year at last count. That means your actual "real" or inflation-adjusted return is 2%. Even after you factor in taxes, which you only pay on the nominal 0.50% yield, the real after-tax return is still nearly 2%.

Compare this with a higher money market yield of 3% during periods of 1.5% inflation. After taxes, the nominal yield is about 2%. Adjusting for inflation, the return is about 0.5% real. Bottom line — a 0% yield coupled with deflation is better than a 5% yield with high inflation for investors seeking safety. 

Deflation is also bad for stocks, but good for cash investors. If we can’t stop deflation, the stock market will eventually slide. And deflation scares us more than inflation, which tends to hurt creditors (bondholders) of relatively long-term bonds. 

Stocks usually inflate with everything else, which makes sense, since stock earnings will inflate just as salaries do. But investors don’t believe this, despite a strong correlation between stocks and nominal (non inflation-adjusted) US GDP over the last century.

The reason for this irrational fear of inflation is the memory of the 1970s era, when inflation soared and stocks performed poorly. But inflation during that period was not the only factor driving stocks down. Stocks began the period at high valuations, and ended at ridiculously low valuations. This P/E compression explains much of the market. Even if inflation had remained elevated, eventually stocks would have taken off again. Another example of deflation threatening stocks more than inflation? The last two decades or so in Japan — although again, much of this can also be attributed to P/E ratio compression.

We’re not sure why the 1970s – a relatively brief era of high inflation in the grand scheme of things – scares people so. Investors tend to have selective memories; the Florida real estate crash of the mid 1920s didn’t keep people from speculating in Miami condos in the recent boom…