Investments
The tides are turning on cash
Recent drops in the stock market had many investors ready to stuff their savings back under the mattress. Not literally, of course, but in an effort to preserve their capital, many Canadian investors allocated more of their savings to safe, cash-type investments, such as money market mutual funds, high interest savings accounts and treasury bills. As a result, there is a lot of cash sitting on the sidelines.
Now that many investors feel they have a better perspective on the credit challenges that affected global markets, we may gradually see a return to confidence – and analysis of past markets indicates that the best time to put cash back to work is before investor confidence returns. Have you ever heard the saying, “buy low, sell high”? Right now may be a good time to reconsider investments that have the potential for superior long-term returns, such as equities and equity segregated funds.
CONFIDENCE WILL RETURN
One way analysts measure investors’ aversion to risk is by comparing the yield paid on bonds issued by large corporations to the yield offered on 10-year government-guaranteed treasury bills. When the difference between these yields widens, it indicates that investors are demanding a higher rate to compensate for taking on added risk.
Chart A illustrates the historical difference in the yield over time. Moody’s AAA yield, a measure of the investment returns offered by corporate bonds, is compared to the yield offered by U.S. 10-year treasury bills backed by the U.S. government. The spread – or difference between yields – shows how investors’ appetite for risk decreased dramatically once the breadth of the current credit problem became apparent.
Before the credit crisis emerged, investors were willing to invest in a corporate bond that paid approximately 75 basis points (bps) – a basis point is 1/100th of a percentage point, or 0.75 per cent, more than a 10-year, government-guaranteed treasury bill.
Once the credit crisis emerged, the only way investors were prepared to take on the added risk of investing in a corporate bond was if they were compensated to the tune of approximately 200 basis points, or two per cent, more than they would have earned by investing in a 10-year government-guaranteed treasury bill.
This kind of dramatic shift occurs when investors back away from higher-risk investments (such as corporate bonds) and move into short-term securities, such as treasury bills, money market mutual funds and other very low-risk investments.
However, the highlighted area of the chart shows that this trend is beginning to reverse itself. Spreads have started to narrow between corporate bonds and government-backed securities, suggesting that the current crisis may be abating. Historically speaking, it is at times like these that investors could begin looking at securities that have greater growth potential than cash, since these trends can often herald a return to above average growth in the equity markets.
CASH UNDER THE MATTRESS
We can also see that within a short amount of time Canadian investors have accumulated a disproportionate weighting in cash and near-cash securities as they ride out the credit storm. Chart B shows how household liquidity – or the amount of cash and cash-equivalent securities – has recently grown at double-digit percentage rates, with some estimates pegging excess liquidity at $45 billion (Chart C). This suggests that Canadian investors are sitting on a considerable amount of money while they wait for the financial markets to begin showing signs of stable growth.
SOPHISTICATED INVESTORS SHOWING SIGNS OF CONFIDENCE
An additional sign that the credit markets may be returning to normal is that sophisticated investors, such as private equity firms, are now finding it easier to borrow large amounts of money to invest. Private equity firms often borrow billions of dollars from investment banks in order to purchase corporations, believing they can manage them more effectively and produce higher profits. Sophisticated investors would be unlikely to borrow these large sums of money unless they were becoming more confident about future prospects for growth.
As new investment opportunities are identified and cash reserves are reinvested in stocks, the financial markets tend to experience significant upward movements. A similar set of circumstances helped fuel the strong market upswing after the bear market that ended in 2003. That boom lasted until 2007.
OPPORTUNITY CALLING
If you would like to benefit from a cash-propelled rally, it is important to invest before other investors decide to return to the stock markets en masse. Many individual investors – still feeling the sting of market volatility – wait too long to put their cash back to work. This can prove to be detrimental to long-term returns. Missing just 20 of the best days over the past 20 years cut average annual returns by almost 50 per cent (as illustrated by Chart D).
CONTACT ME
If you are interested in moving some of your cash back into the markets, but are still nervous about short-term volatility, contact me about balanced segregated funds. Since a portion of a balanced fund’s portfolio is invested in equities, it can provide you with exposure to the upside potential of the financial markets, while the remaining portion is invested in other types of securities that may include bonds, income trusts and money market instruments to help manage risk. There are very effective balanced segregated funds on the market, so it is important to discuss your personal situation with me to help you decide on the best option.
carlbrodie | 
February 11, 2009 12:55 am
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