Cash as a Liability
Credit Risk and the History of Interest Rates – You Now Live in a Historic Moment
Most investors can appreciate or at least acknowledge that interest rates are low by historical standards. But how low? Here, one might make use of a book written by Sidney Homer called A History of Interest Rates. Mr. Homer spent three decades compiling interest rate data spanning 5,000 years. Investment bankers would call this, a “deep dive.”
What will be found in this book is that in the entire recorded history of the world, interest rates have never been as low as present. This is not a casual statement. This study reaches back to the time of the earliest recorded coinage in 3,000 B.C. Sumeria, although other forms of credit existed far earlier. Just a few examples from centers of civilization and commerce familiar even today: in 700 years of lending history in Athens, straddling both sides of the year 0, interest rates were not lower than 6%; in the next few hundred years, through the 4th century A.D., interest rates in Rome ranged from 4% to over 12%; filling out the remainder of the first thousand years of the common era, the Roman capital shifted to Constantinople (lately Istanbul), where for 400 years the loan rate was as low as 6%. We could, of course, go on.
The point is that we, as modern financial investors, are truly in uncharted water. Many have a pressing need for income. But where can such income or yield be found? Government bond rates obviously are low (and by this, we mean the lowest ever). Corporate rates are no better. Investors who want anything above 3% are forced to accept real and undue credit risk, for what – 5%? It’s as if high yield investors are ignoring that they can actually lose principal. Historically, bond investors might have demanded something closer to a 10%-15% yield for the risk that is being assumed today for a fraction of that.
Compounding this problem, yield-seeking investors have turned to stocks. It is no coincidence that stock prices are now at all-time highs. It seems that a new record is broken every week. The sober investor might surely realize that stocks are expensive, with the S&P 500 trading at 18x earnings and at 3x book value. And that doesn’t touch the so-called safer blue chips, like the consumer sector or dividend aristocrat stocks, or the utility and REIT sector shares, which are trading at P/E ratios in the mid-20s. Nevertheless, a large audience believes that the mere 2% dividend yield of the S&P 500 is a superior value to bonds. In their minds, income is unconditionally demanded, and valuation/credit risk is irrelevant.
For investors on both sides of this argument, the following chart should at least give everyone pause. The red line is the 10-yr Treasury rate and the blue line the average equity yield. In scary movies, the audience, if not the protagonists, are warned of danger by the swelling music. One wants to yell out to them: listen to the music! This is the music.
For the first time since the late 1940s, stock and bond valuations have converged to around the 2% level. Once upon a time – say for the prior 80 years – investors demanded higher yields from stocks than from bonds as a tradeoff for the higher risk. Then we learned some formulas, like the dividend discount model, that takes account of the presumptive future growth of those stock dividends. Could both asset classes be overvalued? If nothing else, caution is in order here, and investors should be very thoughtful, perhaps more than at any other time in their careers, about where capital is being put at risk and why.
This is a danger not only presented to financial investors, but to CEOs as well. In an otherwise no-return-on-reserves world, corporations are pressing every angle of their balance sheet for a higher return on equity. An expanding cash balance, which effectively earns no income, actually lowers the ROE, and disenchants shareholders. Oddly enough, cash is now viewed by many as a liability. Some, though, like private investors and owner-operator CEOs, do not believe that cash is a wasting asset. They understand that it protects against credit market dislocations, that it provides opportunistic degrees of freedom, that it is an active strategic asset.
– Published August 19th, 2016
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