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The Cash Horde

Very few of our readers, perhaps none, were alive in 1929 – the year of the beginning of the Great Depression.  Yet, we always refer to that pivotal point in history as a marker on our historical trail of investment performance.  It is commonly heard that, since 1929, the Standard and Poor’s 500 Index has returned an annual average return of close to 10% per year.  Yet, rarely has it returned 10% per year.  Take recent history, as a close-up example of the volatility that exists in equity ownership.

In the year 2008, the market return was a negative 37%.  Yet, in 2009, it partially rebounded with a positive return of 26.5% followed by a positive return of 15.06% in 2010.  (While this sounds nice, I want to remind everyone that, for every dollar invested in the S&P 500 at the beginning of 2008, they would have had only $0.92 at the end of 2010.  The math is as follows: (1-0.37)*(1+0.265)*(1+0.1506)=0.9170, although the arithmetic average return was a positive 1.14% (((-0.37+0.265+0.1506)/3)=0.0114).

The following chart shows the returns for the Dow Jones Industrial Average for each year from 1929 through 2010.  You will note that it rarely has equaled 10% and has been quite variable from year to year.  Frequently, it has decreased by more than 10% but, more frequently, it has increased by more than 10%.  In fact, it has increased by more than 10% in more than half of the 82 years depicted.

Lately, it seems the market has been much more volatile than usual – especially the four days of August 8 through 11 – and it makes one wonder if, in fact, it has become more volatile for some period of time.  Looking back from mid-November 2007 through September 7, 2011 to observe the daily rate of change in the Standard & Poor’s 500, as well as the standard deviation of returns over the 30 days preceding each day, we are able to make some observations.  (Standard deviation is the accepted measure of volatility in a series of numbers which, in this case, are the daily returns.)

This is what we observe: 

The fall 2008 market collapse is where the range in the Daily Rate of Returns (blue) is the widest.   It is also the time period where the 30-Day Standard Deviation rose to its peak, around 0.0508 (November 7, 2008). As we recall, this was a memorable, though regrettable, time in history.  For a moment, however, observe the far right of the chart.  Today’s political and economic uncertainty is being played out in wider swings in the daily returns to the S&P 500 Index and the 30-Day Standard Deviation has been creeping upward since June.

Why do we care?

Hindsight is always better than foresight but, had one known in June that the risks from the market were going to increase over the next three months, one could have purchased put options in June.  (Put options allow the purchaser the right sell securities to a buyer at a specified price on a stated future date.  The purchaser hopes the prices of securities fall, thus giving value to the option to sell at a higher price.)  Moreover, if everything else stays equal, options increase in value the greater the volatility of the underlying assets.  In our example, a put option would have increased in value from both the greater volatility and the lower overall price of S&P 500.  Yet, this is not the motivation for this Financial Tip.

The purpose is to try to answer the question of why American businesses are holding so much cash.  Many believe that businesses should invest their cash in plant and equipment, in order to employ more people.  Many believe that the lack of such investments stands in the way of our financial success.  The cash being held by our businesses, however, is acting as an option.  The cash takes on greater value, from both the greater the volatility and the greater uncertainty existing in the economies of both the United States and the World.  Given the lack of direction and bitter divisiveness provided by those we have elected, as well as those who seek our future support, who can blame the businesses?  “We the people” begins our Constitution, “We the people” are still in charge, and “We the people” must direct our energies towards productive activities and more constructive dialogue.  That is not an option.