Cash on the Sidelines While Investors Wait for Recovery (Commentary by James Bell)

Following the turmoil in financial markets around the world, the level of cash being held by investors has risen to record levels. In fact, by some estimates the total value of money market funds held now exceeds the value of equity mutual funds.

This situation is unprecedented, and with interest rates also at historical lows, it is just a matter of time until some of that cash is redeployed into other asset classes chasing better returns.

Of course, the timing of that shift is unknowable, but there are some historical conclusions to be drawn regarding the buildup of cash and investor behavior moving into and out of cash.

As panicky investors sell into the stock market decline and shift ongoing investment contributions to cash, the level of cash held by U.S. households has grown to $1.5 trillion, 50 percent higher than just three years ago.

Add in funds held by institutions and that number grows to $3.9 trillion. That is in contrast to the estimated $7.5 trillion in stocks and mutual funds held by US households.

Not only is the absolute level of cash historically high, but so is the ratio of cash to equity investments. What implications does that hold for the stock market?

A lot of market pundits paint this cash buildup as a bullish indicator, on the notion that at some point a good portion of that cash will move back into stocks and push them higher. In fact, the last time we witnessed anything similar was right around the equity market bottom in 2002.

The cash alone is unlikely to be the catalyst of a rally, however. Study after study has shown that most investors tend to be late to the trend, either selling after a large decline like we are seeing currently, or buying after stocks have rallied considerably.

Market history has shown that recovery rallies following market declines are often sharp, and investors who are out of the market do not participate. It’s more likely we see a rally and then cash moves into the market, extending the rally further.

Of course there are plenty of good reasons to hold cash, including living expenses, a rainy day fund, and short term big tickets like saving for a house down payment. Our philosophy has always been that funds for those purposes should not be invested in the stock market.

Holding cash right now might be reassuring, and in some ways is a response to the fact that many investors were too exposed to risk and leverage in recent years.

But this huge inventory of cash is somewhat of an aberration.

With money market rates falling below 1 percent, at some point markets will get rational and start to focus on the eventual economic recovery that we are confident America will achieve.

After markets rally, we’ll see this cash move back into stocks, bonds, real estate, and other asset classes that historically offer higher returns. Because the timing of this move is unpredictable, our strategy is to keep long-term capital invested with patience and discipline.