Siding with the Most Reviled Asset of 2011: CASH
A difficulty with contrarian conjecturing is that one is never absolutely sure about whether one is thinking contrarily or not. One can only view the world with one’s own prejudices and belief structures in place, therefore the status of being a contrarian is never certain. So, when acting on contrarian conjecture, it makes sense to oppose trades where sentiment has reached wild extremes. When people seem to be absolutely in love with something, the contrarian can seek to oppose or avoid that thing. Conversely, when people seem to hate something, the contrarian can seek to embrace that thing. This brings me to cash; that is, physical Federal Reserve notes. I contend that the prospect of owning Federal Reserve notes in any size has become completely unpalatable for most investors and speculators. Therefore – as a self-professed contrarian – I contend that it could be highly beneficial to own a significant cash reserve in the coming months and years.
James Grant of Grant’s Interest Rate Observer recently expressed some positive sentiments towards cash in an amusing and lucid manner. I recommend watching the entire interview (see below) if you have 20 minutes to spare, but the particular comments that I’d like to highlight are those at around 17:30mins:
So, think how hard it is to hold back a cash reserve in this time, when cash yields nothing … when the inflation we all see is something more than 0 and cash yields 0. That’s hard. It’s doubly hard because your stupid neighbor who watches this program is making a lot of money in the stock market… You can’t not do it!
The Irony with the Current Monetary Trends:
Not only is the prospect of owning cash revolting from the perspective of what you get (i.e. a big fat 0%), but it also seems like the worst thing to do in this current environment – because the Ben Bernankes of this world are even printing money, right? In Monday’s FTfm, John Dizard expressed his distaste for cash from this perspective:
Right now, thanks to the profligacy of central banks, real interest rates are negative. So why buy the two-year Treasury, let alone T-Bills, rather than gold? Conservative capital preservation strategies are now only ensuring capital destruction.
… Over the decades, though, staying in cash rather than earning assets is as pointless as Scrooge McDuck’s money bin.
The irony with all of this is that the monetary trend is actually in favor of physical central bank notes (as I’ll get to later) and yet the images conjured up by the printing of money leads people to believe and invest in precisely the opposite. This gives rise to the golden scenario described by Humphrey B. Neill in The Art of Contrary Thinking:
The problem of “money” is far too complex for us to examine in this report. It is a study in itself and one which still confuses the great minds of the world. It would be presumptuous for me to attempt a learned discussion of monetary economics.
However, I do wish to leave with you the thought that, because monetary problems are not comprehended by the public or by the average businessman, “money management” will continually cross up public opinions concerning economic trends.
Monetary manipulation is a crafty and tricky tool within a system of bootstrap economics. If you make it a point to become posted on some of the more common practices of monetary management you will occasionally be able to discern trends that are opposite to those commonly discussed in public pronouncements and business stories.
The True Monetary Trend:
I have dealt with the nature of the current monetary trend many times here on greshams-law.com (see here), so I’ll only briefly summarize a few points here.
First of all I should point out that there is a difference between the Federal Reserve notes that you can put in your pocket and the dollar deposit accounts that you hold at the bank. The former are inextinguishable by the private sector whereas the latter most certainly are. It would seem that – in 2008 – the private sector reached a maximum propensity to produce the latter deposit accounts held at depository institutions. Indeed, they had produced so many that they were highly dependent on a continuation of the linear increases in asset prices that had become the norm by 2007. Of course, the cat was let out of the bag in 2008 and the previous trends were revealed to be illusory.
The important point is that, now, when money is printed by central banks, it is printed in the context of a long-term trend of ‘vaporization’ (as Robert Prechter puts it) of IOU claims upon Federal Reserve notes (i.e. deposit accounts). The point is, that the generational trend towards an unwinding of such IOU money vastly outweighs the money printing efforts – or at least, it does for now. So the trend is more towards a ‘scarcity of money’ (as the majority of IOU claims upon Federal Reserve notes disappear), than the ‘abundance of money’ that the typical investor so frantically fears.
The Optionality in the Long Cash Trade:
The optionality in the long cash trade is sneakily concealed from consensual eyes. The denomination of things in money seems to make the potential for gain seem somewhat limited on the short-side, whereas I would argue that the optionality in being ‘long cash’ and/or ‘levered and long cash’ is fantastic.
Owning a stock is often contrasted with selling a stock short. So, the corollary is typically along the lines of ‘you can only make 100% being short’. This – I contend – is somewhat misleading. First of all, I don’t think that it is appropriate to compare owning a stock with selling a stock short. I think that owning a stock can be meaningfully contrasted with simply owning cash, and that being levered and long a stock can be meaningfully contrasted with selling a stock short.
When you own a stock, you can potentially lose the entire dollar amount paid for it, and there is no limit to the dollars that you can gain. Similarly, when you own cash, you can potentially lose the entire stock/bond/house/etc. that you paid for it, and there is no limit to the stock/bond/house/etc. that you can gain. That is to say, the dollar price of stocks, bonds and houses can potentially fall close to (or literally to) zero, meaning that you can acquire many stocks/bonds/houses/etc. with each dollar that you own. Moving on to levered endeavors: When you buy a stock using leverage, you borrow a quantity of dollars to buy a stock. The dollar price of that stock can potentially fall to zero, which would imply that you would lose the entire amount borrowed. When you sell a stock short, you borrow a stock to ‘buy money’. The stock price of that money can potentially fall to zero, which would imply that you would lose the entire amount borrowed.
I hope that the above paragraph made the symmetry in financial markets clear. After all, the financial markets are ‘merely’ places where people go to swap money and things. Neither things nor money have a higher status in this arrangement. If this symmetry is clear, then the optionality in the ‘long cash’ trade should also become clear; the proposition is not that you’ll necessarily make money, rather than your money itself will explode in value (precisely because everyone else suddenly realizes that their money has gone up in a puff of smoke). If one dares to be levered and long cash (that is, to sell assets short), then one can have the double benefit of accumulating additional dollars precisely when each dollar is soaring in value.
Cash seems to be the most hated asset of 2011 – and if it is, then it may pay to own cash in some size (with or without leverage). The above can be summarized with a paradoxical statement: the contrarian should own a significant cash reserve in this money-printing environment because there is great optionality in doing so.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012