I love stocks. That’s why I spend so much time hunting opportunities even in the seasons when the big pockets on Wall Street have essentially given up on the market as a whole.
This seems like one of those seasons. Just about every time I go on TV these days, people ask me some combination of three questions:
- Don’t earnings ratios suggest a dangerous and unsustainable bubble?
- Why are people buying bonds even though it means locking in negative returns?
- Why have institutional investors parked $4.5 trillion in cash accounts paying nothing?
Connect these dots and a casual market observer would think that Wall Street has given up . . . for good reason. Remember, this is big money we’re talking about. “Smart” money. Shouldn’t we be running to the sidelines too?
Not at all. Big money plays by different rules. Wall Street isn’t scared of the future. If anything, fund managers are deliberately accepting negative returns in the here and now because they want to stay open to bigger upside ahead.
They’re not scared. They’re too greedy to accept the opportunities the market currently presents. And that should tell us everything we need to know.
Same Math, Separate Mandates
Consider the basic logic every individual investor learns early on. When we buy stocks, it’s because we expect them to be worth more in the future. We see better things ahead.
But when money rotates into bonds, it’s generally a sign of fear or even a crash on the horizon. A bond rally generally means people are looking for protection. They’ll accept minimal returns in exchange for relative safety.
The only way to make real money in that scenario is if you’re anticipating an upsurge in fear ahead and figure you’ll be able to sell your bonds to people with a more negative view than yours.
Adjusted for ambient inflation, Treasury yields are negative across the duration curve. Buy bonds at this price because you’re scared, and you’re locking in a loss in purchasing power.
Likewise, cash on the sidelines doesn’t exactly demonstrate strong bullish conviction, especially now, when cash pays about 5% less than ambient inflation. You read that right. If you parked $100 in money markets a year ago, you’ve earned up to $0.47 and inflation has taken the equivalent of $5.40 in purchasing power away.
That’s a bad deal. For us to willingly run to cash, we would need to be convinced that stocks were set up to drop farther over the coming year. In that scenario, swallowing a 5.4% inflation-adjusted loss would sting, but at least we could sleep a little easier knowing that the pain wouldn’t get any worse.
I estimate that Wall Street has literally thrown away $270 billion over the past year hanging out in cash. So why is money flowing into bond funds and money market accounts?
Dollar Liquidity Is Undervalued
It isn’t fear. They aren’t betting on a crash. Money managers with an open mandate are buying more stock than ever.
But then you have banks, insurance groups and pension funds that have a mandate to only buy stocks under certain conditions . . . and when they run out of opportunities that fit the profile, all they can do is roll additional capital into cash or bonds.
Likewise, many corporations around the world have bylaws forcing them to keep their cash in high-grade sovereign bonds or money market instruments. The stock market is too volatile for their accountants to tolerate.
And while they have a choice of which government’s bonds to buy, the U.S. Treasury and the greenback remain the favored destination for institutions throughout the world. Yes, you’re committing to swallow close to a 5% loss in the Treasury market if inflation remains where it is . . . but Italian, German and Japanese bonds pay even worse inflation-adjusted returns.
We’re blessed with an economy that weathered COVID more robustly than others. They’re still clawing their way out of the pandemic recession and in many cases fighting much steeper inflation than we are.
Furthermore, now that the Fed has a little more room to raise interest rates in a year or two, long-term Treasury bonds look more attractive than they did even a few weeks ago. People can buy them now, accept a year or two of inflation losses and still theoretically make a little money in the long term.
If your rules force you to own bonds in the first place, the Treasury market is now where you want to be. I’m talking about Asian banks, European banks, financial institutions all over the planet.
U.S. retail investors, on the other hand, aren’t exactly crowding into bonds. Those who are may be honestly frightened of the future or tired of volatility. I understand the impulse. The market hasn’t gotten cloudy, but you’ve simply lost heart. Take your minimal fixed returns and go.
But if you’re trying to make money betting on a crash, here’s a simple gut check. The Fed is already pouring trillions of dollars into the bond market. They have all the money they can print and infinite motive to keep the market afloat.
As the Fed retreats from those purchases, a huge source of demand for bonds goes away. Who will be more deeply motivated to buy bonds in the future than the Fed is now?
At best, I see bond prices climbing 5-6% in a serious stock market retreat. Otherwise, you’re locking in that 5% loss even if demand for bonds remains constant.
That’s not a great risk-return profile unless outside constraints force you to accept it.
But Aren’t Stocks Expensive?
Of course, money has to go somewhere, which brings us back to that first question people keep asking. Buying the S&P 500 right now forces you to pay 21.4X forward earnings expectations.
That’s extremely rich. The idea that anyone will pay a higher earnings multiple in the future is a huge assumption.
After all, short-term interest rates have effectively bottomed out here around zero. The cushion of free money around speculative stocks today is mathematically unlikely to ever get thicker.
And I think this is why big investors have parked trillions in money markets at inflation’s immediate mercy. They aren’t scared. They’re just looking at the big picture and are waiting (just like we are) for a dip they can buy.
They’re waiting for weak hands to fold in order to split a richer pot. They think the reward will be worth paying a 5% toll to inflation in the here and now.
Look at Warren Buffett. He’s the greatest investor in history and he isn’t buying bonds. But he’s stockpiled $145 billion in cash without spending it.
He’s keeping his powder dry. So are we.
Instead of buying a lot of stocks, I’m trading a lot of options. We make money when the market goes up . . . and when it goes down . . . and when it goes nowhere.
Ask how we do it. Get examples. I can be reached through firstname.lastname@example.org.
Occasionally, we’ll lock in a little profit on a stock or two to keep cash flowing across my portfolios. But we aren’t selling everything. We aren’t scared.
Even here at 21X earnings, U.S. stocks look better suited than anything else on the planet to beat inflation and make us rich.
We’ll talk more about that next week. For now, however, just keep the Wall Street adage in mind the next time someone tries to talk you into accepting a negative real return.
You don’t get to be a big player by guaranteeing a loss. We don’t play to lose. Smart money plays to win.