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I began my investment career as a Securities Analyst Intern at Fidelity Investments in the summer of 1981.
In early June, I was invited to lunch with Ned Johnson, the legendary chairman of Fidelity, in his private dining room, along with the other two summer interns.
While serving us a gourmet meal prepared by his executive chef, Ned quizzed us on our best investment tips. This was a precursor to the Idea Dinner immortalized on Showtime's Billions, where the city's top hedge fund managers attempt to outshine each other with their brilliance and investment acumen.
Instead, we were first-year MBA students trying to impress Ned. One intern touted the merits of dominant consumer products companies like Procter & Gamble (PG) and Kimberly Clark (KM). The other touted the growth prospects of the cable TV industry, which has been the delivery mechanism for new programming channels like HBO and CNN, the newly created first 24-hour news network. They raved about P/E ratios, free cash flow projections, and market penetration gains.
Then it was my turn.
I was quite intimidated because Ned was an icon in the industry. He was the first superstar portfolio manager of the Fidelity Magellan Fund. He was the leading figure in mutual funds.
I wondered if Ned was asking a trick question. Fidelity was the largest mutual fund company in the country and had just surpassed $10 billion in assets under management. Eight billion dollars were in money market funds. The money market funds yielded $161,000.
I knew the Fed was in tightening mode because it was fighting inflation, which, though peaked, was still in the double digits. Fed Chairman Paul Volker was determined to keep the money tight until inflation hit. There was an old mantra I learned before business school, when I worked in the financial center of a commercial bank doing asset/liability management: "Don't fight the Fed."
With that quick analysis, I told Ned that I thought the 16% money market funds looked pretty good to me.
Six months later, in my senior year of business school, I was invited to the Fidelity Holiday Party in Boston. I spoke with the head of the research department before the party to say goodbye, and after making up for the semester at school, he wanted me to know that Ned had remembered my answer from that summer lunch and that the market had proven him right. The stock market fell 15% during that period, while money market funds returned 8%.
I tell this story for two reasons: first, the current environment bears many similarities to the summer of 1981, and second, sometimes the most obvious answer is the right one.
We've been in a period of high inflation for over a year now. The highest inflation rate since 1981.
COLD
Fed Chairman Jay Powell insisted the Fed will stay the course until inflation returns to its 2% target.
While there are signs that inflation may have peaked, it is still above the target rate, and there are many indications that the economy is too strong to be confident of sustainably achieving the 2% target. This included last week's surprising increase in nonfarm payrolls of 517,000 new jobs in January and the unemployment rate of 3.4%, the lowest in 54 years.
There appears to be a disconnect between market expectations of a Fed pivot and the Fed's statements that rates will continue to rise and remain elevated for some time.
That old mantra “Don’t fight the Fed” seems appropriate here.
Much of the attention has focused on the discussion of where the Fed will charge rates, but that is only part of its monetary policy.
The second phase is called "Policy Normalization," which is being implemented through a reduction in the Fed's balance sheet. The more common term is Quantitative Tightening (QT). This plan was announced in the FOMC statement on May 4, 2022, and has been implemented since June 2022.
The Fed should reduce its SOMA portfolio, allowing maturing securities to decline, initially by $$47.5 billion per month for the first three months, then by $$95 billion per month going forward.
The Fed is now eight full months behind schedule on QT and the results so far have been lower than initially anticipated.
Federal Reserve
The Fed has yet to meet its monthly bond rollover target and has cumulatively cut just $$416.6 billion from its $$617.5 billion forecast, or $67% from projections.
The Fed's balance sheet, at $1.4 trillion, is only $1.3 trillion smaller than when QT began. While the Fed has been reluctant to explicitly state how much QT it plans, the $1.4 trillion decline hardly affects its $1.4 trillion balance sheet expansion under QT. Normalization still appears to have a long way to go.
COLD
The Fed's aggregate monetary policy of higher short-term interest rates, combined with the drain on bank reserves through QT, creates significant uncertainty about the direction of risk assets like stocks and bonds. Both appear to be negative for these assets.
The 5% solution.
In this environment, one thing is different. For the first time in 17 years, liquidity offers some return. With the Fed's 450 basis point tightening last year, short-term rates rose significantly.
Money has become attractive!
Six-month Treasury bills are hovering around 5%.
COLD
Historically, cash has been the laggard in asset allocation between stocks, bonds, and cash.
Professor Aswath Damodaran of NYU's Stern School of Business compiled the most comprehensive set of historical data for these three asset classes between 1928 and 2022. For this 95-year period, the average annual return for each was:
Shares 9.6%
Titles 4.6%
Cash 3.3%
The standard investing rule is "the higher the risk, the higher the reward," and this rule generally holds true for these long-term asset classes. Stocks are the most volatile over time and offer the highest average annual return, while cash is the safest investment and offers the lowest average annual return.
But for shorter periods of time, the rule does not necessarily apply.
In 2022, as in 1981, cash outperformed both stocks and bonds. In fact, this happens more often than one might think. Professor Damodaran's data shows that cash actually outperforms stocks and bonds 151 times out of 30.
Two of the top investing luminaries currently agree on cash:
Charlie Munger, vice chairman of Berkshire Hathaway, says they hold nearly 201,000 pounds of their portfolio in cash, one of the largest amounts ever. They have so much cash, Munger, the value investor, explains, "because there's nothing we can buy."
Ray Dalio, president of Bridgewater Associates, the world's largest hedge fund, who has long championed the "cash is trash" philosophy, recently changed his tune. Last week, he was quoted by CNBC as saying that cash has become "quite attractive" compared to stocks and bonds.
With much uncertainty as the Fed continues its tightening policy to bring inflation back to the desired 2% level, the 5% cash solution may be the way to go.
This article was written by
I've dedicated my career to monitoring capital markets and managing fixed-income assets. I founded Gray Capital Management LLC and previously served as Head of Taxable Fixed Income at Fidelity Investments. I hold an MBA in Finance from Wharton and a BA in Economics from Union College.
Disclosure: We do not currently hold stock, options, or similar derivative positions in any of the companies mentioned, and we do not expect to open such positions within the next 72 hours. I wrote this article myself, and it expresses my opinions. I receive no compensation for it (except from Seeking Alpha). I do not do business with any company whose stock is mentioned in this article.
