Tuesday, January 25, 2011

Mythbusting Cash

   Years ago, the Internet ushered in a new medium for the flow of information, far surpassing any previous modes in size and speed. Today's world can be characterized by overwhelming masses of information that would likely overwhelm even the highest powered computers. Individuals hardly stand a chance at sorting through all the potential news and research on a given topic, leaving individual minds and the general public vulnerable to accepting largely false information. Theories about the effects of cash on companies and markets over the past several months highlights a topic ripe for misdirection. The goal here is to provide a quick overview of a couple common mis-perceptions before offering articles with further depth and insight on the topic.

   For many months now, experts, analysts and investors in the media have pushed the idea that investors holding excess cash would eventually succumb to a strong stock market. Finally choosing to invest their saved cash would push markets even higher. At first glance, this seems like a perfectly reasonable expectation and it's likely the simplicity has accounted for the mass purveyance of this notion. However, viewing this principle within the confines of basic market exchanges reveals some gaping holes in the theory. To explain this misconception, imagine that you are an investor considering purchasing one share of IBM (closed at $161.44 today). You place an order to buy one share of IBM at the prevailing market price tomorrow morning. Let's assume that the stock opens at the same price tomorrow morning and a current shareholder elects to sell you a share at $161.44. Having matched a buyer and a seller, the transaction is executed. You receive one share of IBM and pay $161.44, while the seller gives up one share of IBM and receives $161.44. Evident from this basic scenario, total cash in the system does not change, but rather shifts between individuals. Now imagine that the price at which you purchase a share of IBM moves up to $170 or down to $150. Either way, the amount of cash switching hands changes, but the total amount of cash in the system remains the same.

   The obvious question in response to this realization is, how does the market move higher? There are many possible answers to this question, but I'll outline a few primary ones. Money flowing out of one asset class and into another (i.e. bonds vs. stocks), can push up one type of asset with an overload of buyers and the other type down with excessive sellers. Another possibility is that total units of an asset decrease, potentially through mergers, buybacks or maturation among other things. As total units decrease, total cash actually increases through the reduction in securities, providing excess cash to push up prices if/when it gets reinvested. Increasing debt or leverage used to purchase securities can also move prices higher as the newly created funds are invested. Over the past two years, mergers and buybacks have increased but so have the number of IPO's, likely maintaining the number of securities available. Most asset classes have been rising together during this period as well. Therefore, a case could be made that growing debt levels and leverage have contributed significantly in pushing stock markets higher. Recent reports suggesting leverage at hedge funds is back near pre-recession peaks supports this conclusion.

   The other large misconception related to cash involves the strength and stability of various companies based on their cash levels. For months, pundits have in unison spoke of the record level of cash on corporate balance sheets as a sign of reduced risk and potential future earnings growth. On the count of large sums of cash aiding earnings growth, the potential is certainly present. Firms feeling confident in their business or pressure to raise earnings can use their cash hoards to buy back stock, purchase other companies, increase production or dividends. As described previously, these actions generally lead to higher stock prices. On the other hand, implying that vast amounts of cash on the balance sheet reduces risk, completely ignores one of the biggest factors of risk...debt.

   Imagine that two separate friends of yours ask for a $20,000 loan in order to start a new business. The business plans and your trust in each individual are identical. The only differentiating factor between the two proposals is the effective "balance sheet" of the different friends. Friend 1 has $10,000 in cash to his name and $5,000 in debt (mortgage, credit cards, etc.). Friend 2 also has $10,000 in cash, but has racked up $50,000 in total debt. Based solely on the cash held by each friend, it appears the risks to loan re-payment are equivalent. However, considering the stark difference in accumulated debt, it becomes clear that offering the loan to Friend 1 is a significantly better proposition.

   Taking this fictitious scenario a step further, let's assume that Friend 2 takes out a $10,000 loan from a bank while awaiting your decision. Friend 2 now has $20,000 in cash and $60,000 in outstanding debt. Based on recent media commentary, Friend 2 is in a better financial position than Friend 1 due to his larger cash holdings. This assumption encourages accumulating greater and greater amounts of debt and masks the risks associated with holding such large sums of debt.

   The above example has been used to highlight the misleading portrayal of strength in corporate America, especially of the largest financial institutions. Readily apparent is that without considering the level of debt held by any individual, corporation, state or country, it is practically impossible to accurately determine the credit risk associated in providing loans. A likely reason that pundits have been remiss to comment on the debt or leverage of corporate America, is that size of debt has been rapidly approaching pre-recession levels.
contractionary economic environment. Can we afford to turn a blind eye to accumulation of debt once again? Although cash is unlikely to be the cause of future recessions, it's benefits are currently being wildly mis-portrayed by the general media. For this with a tendency toward risk management, history shows that being wary of debt offers far more insight than levels of cash. Ultimately, news must be viewed with a more skeptical approach, as the sheer volume leaves all of us prone to accepting half or false truths.

Suggested Reading:

No comments:

Post a Comment