Short-Term Investments: Castles in the Sand

SUMMARY

• Money Markets have seen record inflows.
• However, short-term investments carry reinvestment risks, in our view.
• Stock pullback offers buying opportunity for long-term investors, in our opinion.

There are only two things hotter than this summer’s record temperatures…Taylor Swift tickets and the demand for short-term investments (see chart below). The latter should come as no surprise given that investors have been starved of yield for over a decade. Yields of 5% or higher on T-Bills, CDs and Money Markets seem compelling, especially after 2022’s losses in the stock and bond markets.

According to the Fed, assets in retail money-market funds hit a record $1.5 trillion, surging more than 25% in 2023 alone!

While there is little long-term harm in splurging on this summer’s hottest concert, the same cannot be said for abandoning a well-constructed investment plan or delaying the start of it. This Weekly View highlights a few things to consider before falling prey to the siren song of higher yields and closes with a 3-step reinvestment plan to put cash to work. The recent 5% pullback from late July’s year-to-date high presents a window of opportunity, in our view, to begin such a reinvestment plan.

1. T-Bills, CDs and Money Markets are not Risk-Free: Short-term investments are, by definition, short-term; meaning they mature in less than one year and often much sooner. At maturity the proceeds will need to be reinvested into an unknown market environment. This makes these types of investments sensitive to the many pitfalls of market timing. One could get lucky, and yields could remain high… or unlucky, if yields are lower and stocks are higher. For this reason, portfolios constructed from T-Bills, CDs and Money Market funds can be like ‘castles in the sand’, whose foundations can quickly erode with small shifts in the tides. Thus, T-Bills, CDs and Money Markets carry the highest reinvestment risk of any asset class, in our view.

   A significant reallocation of long-term investments (selling stocks or bonds) to short-term investments is a bet that neither stocks nor bonds will rise by more than the return of the short-term investment. In the case of a 6-month CD yielding 5%, that return threshold would be 2.5% (yields are quoted on annualized basis…a 5% 6-month CD will return 2.5% over its lifetime). Given that the S&P 500 has risen at an average annual rate of nearly 10% since 1928, we think this is a bet with a below average chance of paying off over time.

2. Purchasing Power Risk: Cash equivalents typically provide returns in-line with inflation and no more. In fact, since 2009, short-term rates have generally remained below the rate of inflation (financial repression). Because of this, short-term investments cannot be relied upon to deliver real (after inflation) growth and therefore have historically been a poor fit for portfolios designed to fund significant expenses like retirement, college funding, and second-home purchases. Absent real growth, we believe investors who overly rely on short-term investments today may be forced to cut back on future plans or take more risk later to catch up.
3. Short-term Rates Should Follow Inflation Lower: Today’s high short-term rates have an expiration date because they will only remain high so long as the Fed views inflation as a threat. Whether rates remain high for another six months, one year or more is anybody’s guess. However, the fact remains that as inflation fades, so will short-term interest rates. The chart below highlights the long-term relationship between inflation (blue line) and short-term rates (green line). Note from the chart that inflation typically leads T-Bill yields. Given that inflation has fallen for twelve months, we anticipate that short-term rates will ultimately follow inflation lower.

4. Equity Bull Markets are Unlikely to End When Investors are Flocking to Short-Term Investments, in our View: Markets often move in the opposite direction of the most popular investment trends. Thus, the reason for one of our three tactical rules: ‘Beware of the Crowd at Extremes’. From the first chart on page one, we can see that money flows into cash and cash equivalents have been significant, which has been surprising, given the strength of 2023’s bull market.

A Reinvestment Plan: Merging into Traffic

Reinvesting into a market that is rising can be like an activity that we are all familiar with: merging into moving traffic. For most of us, the action of merging requires little thought because it has become second nature. However, if we take a minute to examine it, we can identify three important steps that can be applied to the reinvestment process.

• Start Immediately: When you are merging onto the interstate, you start the process immediately by getting up to speed. You do not stop on the entrance ramp to wait for an opening because if you did you would lose all your momentum (and your nerve). Likewise, when reinvesting cash, investors should also start the process immediately, in our view. We do not believe that the secular bull market that began in 2009 is over and therefore do not recommend waiting for a significant pullback before putting a portion of cash to work. In fact, the 5% pullback in the S&P 500 from the July 31st YTD high, in our view, represents an attractive window for reinvestment.
• Allocate Opportunistically: When merging onto the highway, gaps in the traffic will appear as you get up to speed. These gaps provide opportunities to merge more quickly. From a reinvestment perspective, investors can designate a portion of their cash to take advantage of opportunities that may arise from market volatility. Historically, market volatility has been high in September and October, which may provide an opportunity for additional reinvestment. In our view, such a reinvestment window would occur if the market were to decline to between 4,200 and 4,300 on the S&P 500, which would be a 50% retracement of the rally that began in late 2022 and coincides with the top of the S&P 500’s ‘decision box’ highlighted in past publications.
• Complete Gradually: Gradually the merger lane comes to an end, and the driver must complete the merge. Reinvestment windows also come to an end because investors risk missing out on the ‘power of compound interest’ if they fail to reinvest in a timely manner. The recent uptick in estimates for the US economy from the Atlanta Fed and S&P 500 full-year earnings (FactSet) are a reminder that the economy and stock market remain resilient despite the regular doses of worrisome headlines. To offset the risk of bad timing, investors can use a dollar-cost-average approach to gradually reinvest on a series of dates over a defined time-period. Three to six months is probably the appropriate time-period for a long-term investor to reinvest their cash, in our view.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.