The Case for Cash

Back in 2016, Meb Faber wrote a post titled, “What’s Wrong With Cash?” in which he advocated for a constant allocation to cash if for no other reason than to curb poor investment behavior.  Of course, at the time Meb wrote the article, cash returns were virtually nil, with three-month Treasury bills (a proxy for cash) yielding around 50 basis points, so peace of mind was about the only return investors could then expect on cash.

Fast forward to 2018, and the case for cash has gotten much stronger.  For one thing, three-month Treasury bills are now yielding roughly 1.3%, which, while still not great, is a lot more attractive than 50 basis points, let alone the near-zero rates that prevailed for most of the last decade.

Secondly, traditional low-volatility assets like investment grade bonds may not be so safe if the economy continues to improve, and interest rates climb.  For one, yields on intermediate-term high-quality bonds (like the ten-year Treasury bond) have remained stubbornly low, meaning that their duration (that is, their sensitivity to interest rate moves) is historically high.  For example, the duration on the Barclays Aggregate Bond Fund (a proxy for the investment grade universe) is the highest it has been over the last ~30 years (via JPM):

Fixed-income investors ignore this risk at their peril.  J.P. Morgan analysts estimate that, as of the end of 2017, a 1% increase in interest rates would mean about an 8.4% decline in the price of ten-year Treasury bonds, and a roughly 18% decline in the price on thirty-year Treasury bonds.  Of course, their anemic coupons would cushion their decline in total return, but not to a significant degree (chart via JPM):

Finally, stock valuations are also historically high, leaving investors little room for error in their portfolios.  Therein, of course, is the true advantage to holding cash:  its optionality, by which I mean the ability it gives holders to be opportunistic when market corrections happen, or when bond yields rise sufficiently to become attractive again.  By acting like the reserve a prudent general holds back for the right moments, cash gives patient investors flexibility, which is an underappreciated trait in an asset.  The best part about cash now is that holders are finally getting paid something for their patience.