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INEFFICIENT MARKETS - The Case for Cash

Most every asset class appears overvalued. Did anyone say cash?

Never before in recent history have the prospects for investors appeared so dismal. This statement may seem absurd. After all, economies around the world appear more stable than ever. Stock markets aren’t so evidently buoyed by irrational exuberance as they were in the late 1990s. Furthermore, the alternative-assets revolution has greatly expanded the range of potential investments. But that’s no comfort when just about every major asset class is perilously overvalued.

In the investment world opportunities normally exist for those who are prepared to stray from the herd. After the 1929 stock market crash, Treasuries soared as the economy collapsed and a severe deflation set in. Investors had even more choices when the technology bubble burst at the beginning of this century. Enthusiasm for the New Economy had overshadowed compelling opportunities in commodities, small-cap and value stocks, real estate, emerging-markets equities and bonds, and so forth.

Today the situation is very different. As Jeremy Grantham of Boston-based fund manager GMO observed in a recent letter to investors, “From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure and the junkiest of junk bonds to mundane blue chips; it’s bubble time!”

GMO employs quantitative models to forecast prospective returns for the major asset classes. Its most recent forecasts, supplied at the end of April, are grim. Over the next seven years, GMO expects U.S. equities to post negative returns. International equities, both large- and small-cap, are also forecast to lose money. Emerging-markets stocks will generate real returns of less than 1 percent a year over the same period. The prospect for bonds is only slightly better. GMO anticipates that bonds of every flavor — U.S. Treasuries, international governments, emerging-markets and inflation-indexed — will produce real annual returns of 2 percent or less over the next few years.

Finance theory teaches that as investors take on more risk, they receive higher returns. In today’s pricey markets that rule of thumb may no longer apply. GMO says a low-risk portfolio, heavily weighted to fixed income, will generate postinflation returns of 2.3 percent a year over the medium term. But if the portfolio’s risk profile is raised by increasing allocations to emerging-markets and international stocks, expected returns actually decline.

Grantham and his crew are not alone in bemoaning the current paucity of investment opportunities. Cambridge Associates is a leading adviser to endowments and pension funds. In a recent client report, the firm observes that U.S. equities are overvalued by more than a third, according to its dividend discount model. Cambridge also finds the MSCI world index “pricey,” while both the Europe, Australasia and Far East index and emerging-markets equities are categorized as overvalued. Among the world’s stock markets, only Japanese and Asian equities are deemed to be “fairly valued.”

In fact, Cambridge is pretty gloomy about investment prospects in general. U.S. Treasuries sported an “unfavorable” valuation at the end of April — a situation improved somewhat by the recent pickup in yields. The firm warns against a “temptation to boost income by owning mortgage-backed or asset-backed issues or lower-rated corporate paper” because such issues tend to have “call features that limit their price rise in the event of an economic contraction or deflationary environment.” European and U.K. debt securities also “remain overvalued, particularly long-duration bonds.”

The Boston-based Cambridge concludes that corporate-bond spreads are “extrapolating today’s abundant liquidity, solid balance sheets, almost nonexistent defaults and strong profitability into the future.” Private equity poses a particular risk to high-rated corporate bonds; unless protected by change-of-control covenants, they tend to be downgraded after a buyout approach.

Real assets also rest on shaky foundations. “The major property types — office, industrial, retail and apartment — remain over- valued,” says the Cambridge report. Forestry used to be eschewed as an illiquid and cumbersome asset. But after Harvard and Yale Universities made a fortune in lumber, the thinking changed. Timberland now attracts “increasingly sophisticated investment groups, including numerous dedicated timberland managers, private equity groups, hedge funds and others,” says Cambridge. As a result, returns from U.S. timberland are set to decline. Grantham, an early advocate of timber investment, laments the “heartbreaking loss of a great opportunity for asset allocators like us.”

Cambridge has long recommended that clients increase their exposure to alternative assets. Now it’s fretting. Long-short hedge funds suffer, it says, from a “crowding problem that is so pronounced that short-side alpha is much more volatile than in the past.” Other hedge fund strategies also confront excessive competition. So much money has been raised for distressed securities that “returns during the next cycle could be meaningfully lower” than in the past.

Private equity is the current darling of institutional investors. Yet Cambridge warns that “U.S. buyouts are very overvalued, given the flow of capital into U.S. buyout funds, increasing leverage ratios and commensurately increasing asset prices. The prospects for European private equity are little better, although Cambridge continues to see buyout opportunities in Asia. Meanwhile, venture capital is still working off its hangover from the surge of overinvestment during the technology bubble and remains, in Cambridge’s favorite phrase, “overvalued.”

In summary, of more than 50 investment classes surveyed by Cambridge, 36 are described as either “very overvalued” (including emerging-markets debt, U.S. and European buyouts, distressed securities and U.S. high-yield bonds) or plain “overvalued.” As a result of the easy credit of recent years, nothing is cheap and little is even reasonably priced. In its 30-odd years in business, Cambridge has never before witnessed such a situation.

What should investors do? Well, faced with prospective low returns, they should think about reducing the costs of managing their money. If one accepts that investment is a zero-sum game in which one player’s gains are offset by another’s losses, it follows that the large fees and transaction costs run up by hedge funds and private equity are bound to diminish investment returns over the long haul. Unfortunately, institutional investors are so wary of being locked out of the better-performing hedge funds and private equity firms that they continue to invest even though immediate prospects are poor.

Then, too, there is the question of asset allocation. Grantham says that if you believe his firm’s data, “you should, of course, put all your money in cash.” Cambridge is wary of recommending such a step. It smacks of market-timing, and market-timers — or “tactical asset allocators,” to give them their proper title — have a poor track record. There are other disadvantages to converting to cash. It has a limited upside and can’t be used to match the long-duration liabilities of pension funds. Institutional funds with large cash positions will underperform their benchmarks if the liquidity boom continues. That makes it difficult to hold the course.

Yet cash has many attractions today — not least, its lack of correlation with other asset classes. There was a time when institutions could pick up a premium from investing in illiquid assets. Now that premium has turned into a discount. The most overvalued investment strategies are in long-dated and illiquid assets, such as private equity. By contrast, cash is short-duration and liquid. In a world where all assets are expensive relative to cash, the case for cash has never been stronger.

Edward Chancellor, an editor at Breakingviews.com, is the author of Devil Take the Hindmost, a history of financial speculation.