Monday, March 24, 2014

Cash - Sometimes King, Sometimes Pretender To The Throne

This is an addendum to my post trying to understand why value investors hate the Fed. In the previous post, I tried to understand why value investors seemed particularly disposed among the investing community to finding fault with the Fed's actions since 2009. I'm not sure any of the answers I received convinced me individually, but as a whole, they offered some interesting parts of the puzzle.

Jason Zweig (whose excellent edited version of The Intelligent Investor was one of the first things I read on value investing many years ago, right after Lowenstein's Buffett biography) said value investors objected to the Fed's actions "because low rates goad naive investors into ignoring fundamentals". That didn't quite answer my real question, which was why value investors were more disposed than other investors to feel that way about the Fed and fundamentals (you can be a growth investor who still cares about fundamentals, I hope!).

But I thought he raised the exact issue where many value investors and I seem to disagree:

1) Low nominal rates on safe assets do not signify low rates for all actors in the economy; in fact, they usually indicate a flight to safety. Low rates on Treasuries rarely "goad" naive investors into heading back into equities until long after the smart money has sounded the all-clear.(Quick digression: I actually agree that extended periods of low nominal rates on safe assets can cause "reaching for yield" behaviour which has pernicious outcomes. But the solution, in my view, is therefore to be more aggressive from a policy standpoint early on. It's the combination of low rates for an extended period of time and a growing complacency among investors that eventually leads to financial trouble. I look forward to reading the recent Brookings Institution piece on whether QE has made financial institutions riskier.)

2) Money and credit aren't the same thing, so it's a mistake when people equate low rates with easy money. Low rates on credit instruments show the price of credit for those instruments. The price of money is of course the inverse of the price level. So when asset and goods prices fall, the price of money is higher.

I think it's perfectly correct to think of cash as an asset class, and weigh its prospective risk/return against other assets (standard mean-variance stuff - for a more interesting view, see global macro investor Jim Leitner's chapter in The Invisible Hands, though unfortunately I can't find a web link). Actually, value investors are particularly good at thinking about cash as an asset class (see Baupost - willing to be in cash as 40-50% of assets; see also Fed-skeptic James Montier on the value of cash). So I find it doubly surprising that they don't appreciate the Fed's actions to maintain price levels on track, and thereby maintain the price of money. 

Perhaps another answer is the (over?) emphasis value investors place on P/E ratios. Miles Kimball noted that low risk-free rates tend to make P/E ratios look high. The anchoring bias of supposedly "fair P/E ratios" can be detrimental. But again, I'm surprised that the value investors I've listed (who are incredibly sophisticated investors) are swayed by this. One of my initial guesses noted the overlap between value investing and conservative political beliefs, despite the Democratic leanings of its most famous exponent, Warren Buffett. I have to say I still find this a persuasive guess for the bias, so I hope that the likes of David Beckworth, Ramesh Ponnuru & Jim Pethokoukis will continue fighting the good fight.

I suppose that once you've decided that low rates are bad, and P/E ratios are high, it's only natural that you find further expansion of P/E multiples dangerous. Matt Yglesias responded that value investors were in favour of policies that depress P/E ratios, which sounds a bit snarky, but it's obviously true that people like to have high prospective returns on their assets. So, if you're a value investor who goes to cash more than other investors, you enjoy it when your cash has a high price compared to assets. 

If I were summarizing how this feeds into a sound investing philosophy:
- An over-reliance on P/E ratios can lead you astray; it may be more helpful to think of investing as harvesting premia when the market's offer is too high.
- Good investors should be willing and able to think of cash as another asset class. Cash isn't always king, but it's nice to have it just before its coronation.

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