Sunday, December 2, 2012

Going to C(r)ash


"Cash" is the most misused term in all of finance without comparison.  Every day, investors including those on Wall Street who should know better, say they are "going to cash" which is a presumed safe haven, even though it's not.  We should have learned the true definition of cash back in 2008, because all of the lessons about what is and is not cash, were on full display, but apparently some lessons have to be learned the hard way.  Back in September 2008 at the height of uncertainty surrounding Lehman Brothers, Mohammed El-Erian the Chief Investment Officer for PIMCO, the world's largest bond trading fund, told his wife to go to the nearest ATM and pull out as much cash as possible.  Why?  Because he of all people should and does understand what is and what is not real cash...

Obviously it was a ludicrous request, since most ATMs only dispense around $400 at a time which is a few days of expenses for most families.  If I walk into my nearest bank branch and withdraw cash, they will give me $3,000 on short notice and $10,000 on a week's notice.  Think about that in the context of a bank run.  Your bank is likely very similar i.e. they won't give you all of your money at one time.

Real cash is only the pieces of paper as you see above.  However, in the finance lexicon, the term "cash" has been bastardized to include electronic cash in the form of "current assets" meaning funds that can be instantly accessed.  In the context of a brokerage account, all brokers "sweep" unused balances into some form of money market fund or bank deposits where they are seemingly instantly accessible.  However, as we were reminded in 2008, money market funds are not riskless and many of them teetered on "breaking the buck" (some did), meaning they garnered losses before being rescued by the Fed.  Meanwhile, with bank deposits, of course these funds are exposed to loan risk.  Bank deposits are insured up to a certain amount, beyond which the investor is fully exposed to losses.

Since 2010, under Dodd Frank (in the U.S.), bank deposits had unlimited deposit insurance, however, that provision expires at the end of this month.  Upon expiration, the limit will be $250,000 of insurance per institution.  Bank's Money market Accounts generally fall under the FDIC insurance of $250k, however money market funds which are usually used as sweep funds for brokerage accounts are no longer insured.  They were only temporarily insured during the 2008 debacle.

Which gets me to the point of this post.  Unless you are someone willing to pull out your entire retirement account to physical cash and bury it in the back yard, I still recommend for U.S. investors (and for that matter foreign investors) to own short-term U.S. Treasury bonds in a brokerage account.  Because not only is there a looming shortage of these bonds as described here, but ONLY the U.S. government's debt is implicitly "insured" (i.e. funded) by the Federal Reserve without requiring any special provisions and/or temporary bailout programs.  In other words, the Fed implicitly backstops the U.S. government because it can (and does) print money to buy U.S. government bonds.  The FDIC which backs bank deposits, cannot print money and has reserves of less than 1.5% of total deposits. So a bet on the FDIC is a bet on the politicians in D.C. coming to a bailout agreement after yet another meltdown, while the hungry crowds on the national mall are threatening to burn the joint to the ground.  There is one implicit risk to owning Treasuries which is the assumption that the boneheads in Congress will raise the debt ceiling for the 79th time.  If they don't, rest assured we will all be living in caves at that juncture.  The easiest way to buy U.S. Treasuries is via an ETF (e.g. SHY or SHV).  Bear in mind, that when interest rates turn negative, and in extreme deflation, they will turn negative, then you will be exposed to rollover risk as in realized losses, as the ETF rolls over maturing positions into new positions.  The longer-term ETF you use, the less rollover risk you will have, but the more volatile will be the ETF as interest rates fluctuate.  These rollover losses will be substantially (if not entirely) mitigated by the fact that prices in the real world are falling, so the real (price adjusted) interest rate should still be positive.

What about Gold?
Having some amount of gold makes sense, as an insurance policy.  However, gold and silver both got whacked this past week and gold mining stocks are in a solid downtrend. As I've said before, gold and silver both tanked in 2008 during that short-term credit deflation.  In full fledged credit deflation, gold can easily sink back to the $400 level or lower, at which point, it will likely be the safest investment once the TRUE money printing gets started i.e. with the fat stacks indicated above...

What about...
The Euro?  Eurozone debt dynamics continue to worsen as indebted nations attempt to borrow their way out of a debt crisis.  When the ECB declared that it would support Spanish and Italian debt, they paved the way for the world's largest carry trade.  Hedge funds borrowed in the U.S. at 1% to buy Spanish bonds at 6%, leveraged up 4x, and sat back waiting for the fat end of year bonus check.  It's no secret that macro hedge funds with European exposure are outperforming this year.  However, when risk assets get revalued based upon the insolvency of the borrowers, that trade will go in reverse - sell Spanish bonds, sell Euro, buy dollars.  Only it will happen a lot faster than that...Canada and Australia?  Tied to China and commodities.  Canada highly leveraged to the U.S. economy. Largely unnoticed, China's stock market just made a new multi-year low this week and commodities like gold, already have one foot out the door.  Plus both countries have a massive housing boom to unwind. It looks like Canada's Central Bankster abandoned ship before he had to clean up his own mess...Japan?  Worst house in any neighbourhood.  By any logic should have collapsed a long time ago.  Swiss? Know it well.  Lived in Lausanne for a year back in '92.  But like other Central Banks, not afraid to print money.  Again, it comes down to the carry trades, when those get unwound the dollar will scream higher, so anyone in the U.S. has currency risk. And don't even get me started on U.S. Municipal Bonds.  Suffice to say that's where the Romney Class is hiding, so that's where the bodies will be buried. Bearing in mind with my off-the-cuff analysis above, only a fool speaks with certainty about uncertain things...

The Bottom Line
Every investment vehicle today involves some amount of risk.  There are no true safe havens.  In all cases, we need to be explicitly aware of who is the counter-party involved, and what is their ability to pay when under duress.  With gold, the implicit counter-party is the next guy who is willing to come along and pay up for your gold even though he may well have other more important things to spend his money on at that juncture, like Top Ramen and Kraft Dinner...

And at risk of stating the obvious, we should all get some cash on hand of our own, before El-Erian's wife shows up again at the ATM...

INVEST AT YOUR OWN RISK