Picture, if you will, a mountain. The mountain reaches high into the sky, piercing the clouds and dominating the landscape. But this isn't your typical mountain. Its slopes are made not of rock and stone, but of cash: bills and coins of all kinds, certificates of deposit, Treasury bills, money market mutual funds...
As extraordinary as the metaphor seems, it's not far from the truth. There is currently an enormous reserve of cash assets piling up around the world, as investors wait - for a catalyst, for an improving economy, for more certainty - before they invest in equities and high-yield bonds again.
This is a counterproductive strategy. You pay an extremely high price for financial certainty, and in times of extraordinary turmoil (such as we've experienced over the past year), the price is even higher.
Take a look at the graph accompanying this article. It compares the total assets invested in money market funds (essentially a proxy for cash) to the market capitalization of the broad-based S&P 500 stock market index.
Note how direct the inverse relationship between these two assets has been, particularly since 1998. If you understand market history (and investor psychology) you'll know why: Every time the bulls run on Wall Street, investors pull their money out of cash and put it into the market. Conversely, every time the bears hold dominion, investors pull their money out of stocks and put it into cash.
The most cash tends to go in just before market peaks as investors chase performance. Conversely, the most cash goes out of the markets at lows.
In this way, the graph functions as a kind of "fear gauge," measuring the amount of fear in the market: The more fear, the more money in cash.
Looking at the far right of the graph, you can see how extreme the fear has been during the current downturn. Simply put, there has never been another point in history where there has been such a dramatic shift in the ratio of cash to equities.
And that means opportunity - not only to high-net-worth investors, but everyone else too.
The graph is one of the strongest arguments for a rebound in the stock market, and also in the investment-grade corporate and high-yield bond space.
You'll note that every time we've seen a similar mountain of cash holdings, there has been a market bottom. And it's easy to understand why. This record level of cash is currently generating perhaps a 1- to 3-per-cent return before taxes and inflation. No investor I have ever met is satisfied with this kind of meagre return. The money has to move off the mountain soon.
Most of the top-level investment managers I've talked to - the Sherpas of the financial world - seem to agree with this general argument. As a result, they've become much more bullish over the past few months, unwinding their short positions and becoming excited again about opportunities.
Will there be further volatility? Almost certainly. In fact, we wouldn't be surprised to see the markets pull back by 5 to 10 per cent as traders take profits over the next several weeks. But it doesn't change the central thesis: There is no way investors with cash will be satisfied with the existing paltry returns. Or to return to our metaphor, this money will come down from the mountain soon.
We are currently at an inflection point, a point where the market could experience a quick, dramatic turn for the better. High-net-worth individuals are starting to realize this, and they're entering the market before the majority of investors move their cash "off the mountain."
I believe this to be an important feature of the high-net-worth mind. At the end of the day, high-net-worth investors have a higher batting average than investors with more modest portfolios. They make the right investment moves more often, not because of their superior intelligence, but because of their superior temperament.
Over the years, I've noticed the following characteristics of successful high-net-worth investors.
They are contrarians. They are skeptical about following the crowd. Throughout the current downturn, most high-net-worth clients have followed the sage advice of Warren Buffett, becoming fearful when others are greedy, and greedy when others are fearful.
They unearth opportunity sooner. They have trained their minds to identify and act upon business and investment opportunities quickly. When I show the graph to clients, the vast majority of them see the opportunity immediately.
They think longer term. They don't think day to day, paycheque to paycheque. Right now, our clients are making investment decisions with a three- to five-year investment horizon in mind.
They have more courage. They have the "stomach" for investing; they have the discipline and the nerve to take calculated, well-considered risks when there is appropriate reward.
You can see how each of these characteristics has important implications in the context of the current market opportunity. High-net-worth individuals want to move into the market before the mountain of cash moves.
© 2007 The Globe and Mail. All rights reserved.
