FINANCIAL MARKET UPDATE 8.24.2021

STORY OF THE WEEK

THE HIDDEN RISK OF HOLDING TOO MUCH CASH

The current market environment has some investors feeling uneasy. The S&P 500, which represents large companies in the US, has been hovering around record highs. Meanwhile, stock valuations are stretched, the Federal Reserve could be forced to tighten monetary policy sooner than expected due to inflation, and the surge of the Delta Covid-19 variant continues to interrupt business activity and supply chains. With this backdrop, it makes sense that some people would be hesitant to put more money into the market. While keeping assets in cash is an effective way to limit portfolio volatility, doing so can expose investors to other risks.

With interest rates currently held near zero, the yield potential for cash is non-existent. At the same time, inflation has been running at the highest levels in years, leading to a negative real (inflation-adjusted) return on cash. In effect, investors that opt to remain in cash rather than invest in the market today are exchanging the possibility of market volatility for a certain decline in the purchasing power of their assets.

The table below illustrates the annualized real return for a variety of asset classes going back 95 years. As you can see, at 0.38%, cash has historically returned slightly more than inflation. Bonds have outpaced inflation by a solid 2.13%. Stocks show off their wealth-creating potential, having exceeded inflation by 7.32% per year.

In addition to calculating the annualized return over the entire period, we also calculated rolling 10-year returns¹. There are a few critical takeaways from this data:

• Cash had by far the most 10-year periods with a loss of purchasing power (448), followed by bonds (254), while stocks had the fewest (140).
• A traditional 60/40 portfolio of stocks AND bonds experienced a loss of purchasing power in fewer periods (116) than any of the individual asset classes alone.
• Stocks had the worst 10-year real return of any asset class (-45.33%). What is shocking, however, is that cash experienced a loss of purchasing power that was basically as devastating as the worst period experienced by stocks (-42.08%).
• A traditional 60/40 portfolio of stocks AND bonds had a smaller loss during its worst 10-year period than any of the asset classes alone.

Source: Morningstar Direct. Analysis form 1/1/1926 – 7/31/2021. Includes all 10-year periods using monthly returns. “Rolling” means all 10-year periods calculated in 120-month increments. Returns are annualized and inflation-adjusted (real). Stocks are represented by the IA SBBI US Large Stock Inf Adj TR USD Ext Index, cash is represented by the IA SBBI US 30 Day T-bill Inf Adj TR USD Index, bonds represented by the IA SBBI US IT Govt Infl Adj TR USD Index. The 60/40 portfolio is 60% stocks and 40% bonds, rebalanced monthly. 

The graph below provides a good visual of the rolling 10-year return periods. In it, we compare the experience of an investor in a diversified 60/40 portfolio of stocks and bonds with an investor that chose to remain in cash. There were certainly periods where the 60/40 portfolio underperformed cash after inflation. Still, the all-cash allocation generated a negative real return more frequently, and its worst periods of negative return were more severe than the diversified alternative. Importantly, the attempt to limit portfolio volatility came at the expense of a significant degree of forgone upside, as the diversified portfolio soared above cash during the good times.

Source: Morningstar Direct. Analysis form 1/1/1926 – 7/31/2021. Includes all 10-year periods using monthly returns. “Rolling” means all 10-year periods calculated in 120-month increments. Returns are annualized and inflation-adjusted (real). Stocks are represented by the IA SBBI US Large Stock Inf Adj TR USD Ext Index, cash is represented by the IA SBBI US 30 Day T-bill Inf Adj TR USD Index, bonds represented by the IA SBBI US IT Govt Infl Adj TR USD Index. The 60/40 portfolio is 60% stocks and 40% bonds, rebalanced monthly. 

While the desire to protect one’s assets from volatility is understandable, an attempt to minimize portfolio fluctuations has the potential to expose investors to other risks. The impact of inflation is not as readily observable as the day-to-day fluctuation of a portfolio’s value, but it is every bit as consequential to the ability to fund future spending needs.  For long-term investors, what really matters is the preservation of buying power, NOT the preservation of capital. Historically, a diversified portfolio has been more successful in accomplishing this goal than cash.

1. Rolling 10-year returns were calculated in 120 month increments, beginning with the first 120 months in the observation period and advanced one month at a time.

WEEK IN REVIEW

• Minutes from the July FOMC meeting, released last week, showed that Federal Reserve officials believe it may be appropriate to begin tapering asset purchases by end of the year. Officials stressed the need to “reaffirm the absence of any mechanical link between the timing of tapering and that of the eventual increase in the target range for the federal funds rate.” Look for more details this week from the Kansas City Fed’s annual conference (typically held in Jackson Hole), where Chairman Powell is expected to provide some additional clarity on the committee’s views.
• Earnings season is coming to a close, with over 90% of companies having reported earnings as of August 13th.  87% of companies that reported beat earnings estimates, while the YoY earnings growth rate increased by approximately 89%.
• Economic data to be published later this week includes durable goods orders on Wednesday, jobless claims and a GDP revision on Thursday, and inflation data (PCE) on Friday.

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Source: MarketWatch