Investors’ cash pile is smaller than it appears

Good morning. For want of actual market moves to write about, today we look at one popular bull argument for later this year: the great rotation out of cash. Tomorrow’s Unhedged will be written by our esteemed colleague Jenn Hughes. But you can email us anytime: robert.armstrong@ft.com and ethan.wu@ft.com.

About that cash pile

One of the most popular bull narratives for risk assets in 2024 is the huge amount of money sitting in cash right now. The idea is that while cash has a high yield — 5 per cent or thereabouts — as the Federal Reserve cuts interest rates those yields will fall, and cash holders will go in search of assets with higher returns, such as stocks and corporate bonds. Here’s a chart of assets held in US money-market funds: 

The story of dammed-up lakes of cash ready to spill appears pervasive across markets (chart from Bank of America):

We hasten to note that we don’t believe in the “cash on the sidelines” fallacy. When cash is used to buy shares, the amount of cash in the system does not change. There is no such thing as financial transubstantiation. The argument, instead, is that when investors want to reduce the share of cash in their portfolio, they try to trade out of it. This effort to be rid of cash is, at the level of the whole system, futile. But the accompanying increase of the velocity of money in the financial system pushes prices of risk assets up.

That said, the “cash will seek a new home in risk assets” bull story has another issue, which was pointed out to us by Absolute Strategy Research’s Ian Harnett. The level of mutual fund cash is actually not that high, compared to the market capitalisation of the stock market. Here is ASR’s chart, showing that the money market assets/market cap ratio is near its historical average:

What matters, for the purposes of moving markets, is the volume of money that is trying to rebalance away from cash, relative to the amount of non-cash assets that are available. So the great money-market fund exodus might not move markets as much as bulls hope. That being said, a lot of investors might want to rebalance from cash to fixed income, so the most relevant ratio might be cash holdings to the market capitalisation of stocks and corporate bonds, and one might want to consider longer-term Treasuries, too. That might change the picture somewhat.

Two more stocks of interest

We have already written about three of our entries in the FT’s 2024 stock picking competition: Everest Group, Cigna and Dollar Tree. To repeat, our strategic bet this year is that “Garp” stocks — those that offer growth at a reasonable price — are going to outperform with an uncertain economic backdrop and where big-cap growth looks like a crowded, expensive, hyped trade.

The contest allows for five stocks, long or short, so we have two to go. Next up is General Dynamics, an industrial group that produces civilian aircraft, notably Gulfstream jets (about a fifth of revenue) and supplies the military with equipment from ships and submarines to IT systems (the rest). It has been a slow grower historically, but Wall Street thinks it’s possible that revenue and sales growth will be in the mid-single digits, or better, this year. It trades at less than 17 times this year’s expected earnings, and it generates good free cash flow.

The pitch for the upside is twofold. That aerospace growth has been a bit weak, a fact that management puts down to supply chain issues; if those problems lift, that segment could have a good year. Furthermore, while the company’s military businesses have grown rapidly recently, their margins have been a bit soft (a normal pattern when new products roll out). Hopefully there is room for improvement there, too. And, the world being what it is right now, having exposure to the defence industry doesn’t seem like a terrible idea. One note: GD reports fourth-quarter earnings tomorrow. Depending on what we hear, we might change our minds before the contest closes on January 28.

Lastly, Expedia. The online travel stock shot up 60 per cent in the last two months of 2023, after strong third-quarter earnings. The company has generated impressive five-year compound earnings growth of 14 per cent. But even still, Expedia trades at 12 times forward earnings, at a discount to its peers, and the stock price sits about where it was in 2017.

No doubt the cheap valuation reflects risks: consumer travel is competitive and economically exposed, often requiring significant marketing spend to acquire customers. And Expedia, which owns the likes of Hotels.com and Airbnb competitor Vrbo, has struggled to make its scattered assortment of travel sites run on the same back-end technology.

What has impressed about Expedia, though, is its ability to expand margins as travel bounces back from the pandemic. Ebit margins are 3 percentage points wider than in 2019, fuelling a 43 per cent rise in operating income even as revenue has grown just 4 per cent. Greater focus on higher-margin hotel bookings has helped. Expedia has also poured those profits into share buybacks, which hit an all-time high of $607mn in the latest quarter. The optimistic case, then, is continued margin expansion helped by a healthy travel market and better tech integration, from the starting point of a reasonable valuation.

Now, step back and look at the portfolio as a whole. Under what circumstances will it do well? Five long positions in five very different industries (property casualty insurance; discount retail; health insurance; aerospace and defence; travel). That diversification conceals the fact that there is a very heavy defensive/non-cyclical tilt. Except Expedia, all the stocks are defensive-ish (Dollar Tree is a bit of a complex case). If growth roars again in 2024, this portfolio is going to underperform the market. On the other hand, if the economy slows down, and worries about a recession resurface, the portfolio will be in a good shape to outperform the market.

One worry is that the portfolio is just too boring to win a stock picking contest. Good “Garp” stocks tend to compound along over the long term, rather than soaring in a given year. But we think these companies have enough idiosyncratic risk (Dollar Tree’s turnaround, Expedia’s fight for market share, the outlook for global defence spending, Everest executing on its growth plan) that if the stars align we could have meaty gains.

The real risk, of course, is that we are not stock pickers. Picking stocks that beat the market is really hard; in the absence of good luck, it may be impossible. Doing it well requires a huge amount of work. By contrast, we picked a broad strategy (Garp), ran a screen of S&P 500 company financials, and found five stocks that fit the strategy. It is all but certain that there are things we should know about these companies that we don’t, and we are very likely to find some of these things out the hard way. This is a stock picking contest, not investing.

Why do we bother, then? Because it’s a fun challenge and a great way to learn about markets. You should join the contest — and email us your picks!

One good read

More on those frozen Teslas.

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