Description

Hi, guys --

This is easily the most liquid, highest quality and biggest idea I've ever submitted -- can't wait for the low ratings & mocking tags to start rolling in! As usual, though, this isn't suitable for all accounts; many of us can't hold significant amounts of cash/near-cash for psychological, institutional or compensational reasons. If you're in that position, well, sucks to be you and feel free to skip the rest of the write-up, which honestly isn't that interesting to begin with.

Note I'm not recommending that anyone go to cash, just that it's a great time to think about increasing your allocation if that's consistent with your mandate.

1: Cash As A Fixed Income Investment

I'm going to take a lot of short-cuts here because I'm writing this at home and the analytics are at work. I think cash/near-cash is far and away the best domestic fixed income investment out there and that the only reason to put money anywhere else is because you're forced to, have special insights into a particular issue, or have precise macro views.

Here's a recent yield curve from treasury.gov:

Here are the durations, courtesy of the WSJ:

Duration means, if rates move up/down by 1%, bond prices will go down/up by X%. The curve is flat as a pancake; you're picking up only 60bps for extending from from 1yr to 30yrs. Because rates are so low, the duration curve is quite steep. And because rates are so low, the payoff function for duration is asymetrical; roughly speaking, looking at the 10yr, you lose 8.5% if rates trend toward long term averages, and make 8.5% if we return to the lows of absolute screaming chaos and madness. The only reason to extend beyond 2 yrs is because you have to (mandate, liability matching, spread business, whatever) or because you're really bearish and the only way to express that view is by going long duration.

I don't see taking on credit risk as being rewarding, either. High yield spreads have been lower during the run up to the financial crisis in the mid 2000s and the telecom boom of the late 90s. HYG, the benchmark ETF for high yield, has a 5.13% coupon. That's not great.

I'm going to elide discussion of investment grade credit, you can just interpolate between treasuries and high yield.

2: Cash As A Portfolio Allocation

I'll be extra brief here. What's great about cash from an MPT/efficient frontier point of view is that you get some return with zero volatility. You don't have to believe in that stuff, I don't much myself. But cash is an asset class. How much of it should you hold? The answer is unlikely to be zero. Maybe it's negative and you're margined. Maybe it's positive and you have to face the discipline drain of seeing 3% (or whatever %) of your AUM idle and begging to be put work. But it's probably not zero. In this environment, I think it's greater than zero.

Although not part of the theory, it's also nice to have a zero vol asset that you can rebalance out of.

3: Cash In Times Of Extreme Uncertainy

The continuation of the currently quite rosy macro backdrop is as uncertain as it's been in my experience, and I go back a ways. Just to establish some street cred as a soulless bankster sociopath, I regarded the market reaction to the airplane attacks in 2001 as a buying opportunity. The anthrax was worrying for a few days until it became clear that the biological warfare campaign wasn't being conducted on any great scale. This all about the (risk-adjusted) Benjamins, not ideology.

Donald Trump has been great for US stock prices but I don't see what he's going to do for an encore. Cutting corporate tax rates is just ... obviously good. The rest of the policy agenda, well, speaking as a soulless bankster sociopath, could we let that drop? Trade wars and ethnic nationalism might well be best for the nation in the long term, but I'm unclear as to how those policies increase earnings or multiples in the short term while being very worried about unintended consquences decreasing earnings and policy uncertainty decreasing multiples while we're waiting for the long term benefits.

There's going to be another Presidential election in two years. Absent, or even with, a convincing victory, the legitimacy of the outcome will be questioned.

I have no idea what's going to happen next; not to US stocks, rates, VIX, oil, EM stocks, Mongolian real estate, fracking sand, etc., so I'm going to raise cash until I can figure out what the hell is going on, while taking some degree of comfort from the high price of certainty being the lowest it's been for some time.

4: Implementation

The details really don't matter much. The guy who runs the cash desk at work is sourcing 3-10 day high grade commercial paper at 2%. I'd do that if I could. Given the current term structure, I wouldn't go out further than 1 year. The difference between that and shorter maturities depends on exactly how you think rates will evolve, which is beyond the scope of this note.

There are a variety of ETFs that invest in short term debt. I'm not going to recommend one, because everytime I look at them I fall in love with the one with the highest yield -- yow! 2.4%! -- which isn't the point.

Full disclosure wise, I'm 5.5% in cash. That's likely to go up as some winners qualify for long-term capital gains.

Yours,

Bowd

Catalyst

None, but you might thank me for this some day.