Rates 'Higher For Longer': Forget Stocks, Cash Is King

Investing in stocks is generally considered to be superior to holding cash because history has shown that equities have the potential to provide higher returns over the long term. For example, investing in mainstream indexes through their tracking ETFs like the S&P 500 (SP500)(SPY)(VOO), Dow Jones Industrial Average (DIA)(DJI) and the Nasdaq (QQQ)(NDX) has yielded significant outperformance over the long-term relative to cash proxies like money market funds:

This is because, buying stocks is in effect taking an ownership stake in a company, and as the company grows and becomes more profitable, the value of your investment can increase. Cash, on the other hand, is a low-risk asset with little to no potential for growth and merely pays out interest to investors. As a result, the growth potential of stocks, combined with dividends that some companies pay to shareholders, can provide a higher rate of return than the interest earned on cash.

This is particularly true over the past several decades when interest rates have been historically low:

However, at times when interest rates soar, there are moments where the interest rate offered by cash generates superior cash flow to that offered by dividends. As a result, the impetus is then on the companies to generate robust growth to drive capital appreciation which - combined with the dividends - can outpace the interest paid by the cash. In addition, the growth rate should also exceed the interest payments on the cash by a healthy margin to compensate investors for the risk they are taking on to invest in the company, since cash is a relatively risk-free investment whereas businesses encounter all sorts of risk.

As a result, if stocks become too pricey and the economy falls on difficult or simply uncertain times simultaneous with rising interest rates, cash can actually be a superior investment. This was definitely the case over the past year, where bloated stock market valuations combined with geopolitical and macroeconomic uncertainty and rapidly rising interest rates to deliver underwhelming stock market returns and outperformance for cash relative to the stock market:

Meanwhile, today, cash looks to be more promising than ever. While stock prices have retreated significantly from their all-time highs right at the beginning of 2022...

...interest rates have risen even faster:

As a result, today the Federal Funds Rate is roughly three times the yield on SPY, about 160 basis points more than what is offered by the Utilities sector (XLU), and nearly 100 basis points higher than what is offered by the U.S. REIT sector (VNQ). On top of that, Federal Reserve Chairman Jerome Powell just recently stated that interest rates are likely to go higher than previously anticipated, so further upside is likely in store for interest rates, which will further erode the relative value of stocks.

Furthermore, rising interest rates serve as a double-whammy to stocks, especially given how addicted to debt the corporate world has become. This is because rising interest rates generally reduce earnings growth for most companies due to an increased cost of capital (thereby reducing investment in growth opportunities), increasing the cost of consumer spending (thereby reducing demand for companies' goods and services), and increasing the cost of servicing debt on the companies' balance sheets. After a decade of debt-fueled buyback frenzies across the corporate world, the effect of rising interest rates is more impactful than ever:

When combining stubbornly high inflation with rising interest rates and already stagnant economic growth, it appears that a recession is all but inevitable at this point. This means that in the near term, stocks are actually likely to experience negative growth. Furthermore, simmering geopolitical tensions between China, North Korea, Iran, and Russia on one side and the West and regional rivals of its aforementioned adversaries (i.e., Taiwan, South Korea, Israel, and Ukraine among others), mean that a major war could very plausibly break out in the coming years. In such a scenario - especially one involving China - the stock market would almost inevitably crash, making cash a big winner.

As a result, the case for buying stocks over holding cash in an interest bearing account like a money market fund or even a 1-3 month treasury ETF like the iShares 0-3 Month Treasury Bond ETF (SGOV), is getting harder and harder to make.

Current money flows reflect this as well. Total assets under management in the big index funds as well as in once-red hot technology funds like Ark Invest's Innovation ETF (ARKK) are plunging:

Meanwhile, recently tens of billions of dollars have been flowing into money market funds on a weekly basis. In fact, in recent weeks, money market funds have reportedly been the only group of funds to log net inflows consistently as even bond funds are taking a beating alongside equity funds. This reflects the clear reality that interest rates on short-term cash funds are compelling relative to the total return profile offered by bonds, as long-term interest rates are no longer attractive relative to short-term interest rates:

Moreover, with the stock market still considered overvalued by many leading valuation models along with the aforementioned near-term growth headwinds for the economy, there is little to excite investors about the indexes either, especially relative to the interest rates currently being offered on cash.

Investor Takeaway

While the total return generated by stocks has crushed that generated by cash equivalent investments such as money markets and short-term bonds over the long-term, these are unique times. Since the beginning of 2022, cash equivalents have materially outperformed stocks and bonds and - with short-term interest rates all but certainly headed higher before they head lower and a recession increasingly likely to hit soon - cash continues to look like it is king in 2023 and potentially beyond.

That said, it is important for investors to keep in mind that macroeconomic factors can change quickly and unexpectedly and that it is extremely difficult to predict market behavior over a short period of time. Furthermore, given that stocks have a remarkable track record of thoroughly dominating the total return performance of cash-related investments over the long-term, in our view it is likely imprudent to completely dump stocks and flee to cash. In fact, for long-term oriented investors who do not need to touch their principal for at least three years, it makes sense to remain nearly or even entirely invested in stocks.

On the other hand, for risk-averse investors due to personal financial circumstances and/or personal psychological make up, it may make sense to adopt a larger cash allocation than normal in these times. Given that I am in my 30s and am earning a steady income that easily exceeds my living expenses, and the fact that I am finding numerous attractively priced high yielding opportunities that are likely to weather a recession just fine, I am still nearly fully invested in stocks and only have a small position in SGOV.

Our 2023 Blowout Sale of the Year is Here!

For a Limited-Time - You can join Seeking Alpha’s #1 rated community of high-yield investors at a steep discount!

Try it Free for 2-Weeks. If you don’t like it, we won’t charge you a penny! We have over 150 five-star reviews from happy members who are already profiting from our high-yield strategies.

We spend 1000s of hours and over $100,000 per year researching the market for the most profitable investment opportunities and share the results with you at a tiny fraction of the cost.

                 (Limited to only 50 spots!)