Cash could be the next bubble
Archived Articles 03 Nov 2008  EWR
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The relative price of cash has soared recently. Is there any fundamental support for this, or are we seeing a cash-bubble, i.e. a negative asset-bubble forming?

Sometimes investors, for one reason or the other, get very carried away by a specific asset class. In Estonia some years ago, everyone thought that real estate was the superior investment whose value could never fall. An investor would say, "wages are rising and construction is getting more expensive, of course prices cannot fall". Internationally until recently, oil was widely believed to be a low-risk investment. Investors would say "oil is a finite resource, international demand rises, but supply is limited and reserves are being depleted". Investors into gold and commodities have had their strong opinions as well.

But what is often overlooked in these seemingly logical ways of thinking, is that they lack any kind of conclusion about what is a justified price level. The arguments are only about directions, never about levels. And if the justified level of a price cannot be determined, it follows that neither could its direction. It boils down to predicting the behaviour of other market participants. But everyone is trying to predict and forestall everyone else.

For the single Estonian real estate investor it might have been perfectly logical to buy. It was probably a long-term investment, his financial position was strong etc. But what is logical on an individual level may be illogical on an aggregate level. Everyone was looking for real estate at the same time, everyone with their good reasons, but their aggregate behaviour pushed prices to unsustainable levels. Again people had no clue about appropriate levels, only a vague relative thinking of "things will get more expensive because demand is high". Price-bubbles were created.

So, people look at their own investment situation, but have difficulty in seeing the price effects due to the behaviour of others, i.e they do not know what the market has "priced in". In this respect asset prices behave like pyramid-schemes. The lower the cash-flow of the asset, the better the pyramid-scheme analogy. Those who are early into a new market-trend benefit from the demand of those who follow. Those who are followers suffer from the high prices caused by the early ones.

So what about potential bubbles today? During the last few months on the world markets, the preference for cash and cash-equivalent instruments has soared. The demand for cash has been huge for a number of reasons: e.g. transactions, protection and speculation. The preferred type of cash has been the US-dollar. Basically all hard asset classes have fallen in price relative to cash, i.e cash has become increasingly expensive measured in real assets. Nobody can calculate whether today's price of cash is high or low, but it is clear that the preference for cash has increased dramatically lately. Thus there could be a negative asset price bubble forming, i.e. a cash-bubble.

Clearly the accumulation of cash has been logical for a lot of investors around the world, but investors may have forgotten, or been unable, to look at cash positions on an aggregate level. This includes major currency reserve-holders such as China, Japan and Russia (cp. "Money is a risky asset" BBN 28. May). As central banks now try, and finally will succeed, to reliquify the markets, this could tilt the balance away from this cash-preference. And as cash-investors realise that they are all sitting on a huge amount of the same asset, markets' opinion on cash could turn 180 degrees. Strong deflationary forces would abruptly be replaced by inflation.

The speed at which delevering has evolved during the last few weeks, and the importance of forced asset sales (=forced cash-purchases) could indicate the build up of a cash-bubble. Crashes and bubbles are inter-related.

The ECB is currently lending unlimited amouts of cash in their weekly repos to the European banking system at an interest rate of 3,75%. Considering this, from an Estonian perspective it is noteworthy that a stable cash-flow asset such as the Eesti Telekom share now yields close to 20% (profit before taxes/market capitalisation). Another indication of a cash-bubble forming comes from Russia where the stock-market has been sold down by some 80% from its peak, just as people are hoarding US-dollars.

If we do indeed have a cash-bubble today, we will sooner or later see this demonstrated in surging asset- and consumer prices. A significant part of the stock market crash would be reversed.

Stefan Andersson, private investor 27.10.08 08:55
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