Investors should by now be accustomed to how the Permanent Brown Portfolio allows them to achieve a 3% to 4% real return (above inflation) during peacetime by equally allocating investments across four asset classes, which should form the backbone of every portfolio throughout the business cycle. They should also understand that by actively managing their asset allocation based on the business cycle, they can achieve higher real returns over time. Among the four asset classes, which are divided into contracts (cash and bonds) and properties (equities and gold), one asset class has historically been considered King: CASH.
Investors should first define cash in investing terms: short-term, low-risk instruments or accounts offering liquidity and modest, interest-based returns. Designed to preserve capital, cash investments suit those prioritizing safety over high-risk options. Easily convertible within 90 days, they are backed by governments, banks, or reputable institutions, ensuring capital security. These investments typically offer predictable returns through fixed or variable interest rates and have short maturities, from a few months to a few years.
In John Exter's Inverted Pyramid of Risk, cash and physical gold rank among the lowest-risk assets. During credit expansions, capital flows upward toward higher-risk, lower-liquidity assets, amplifying theoretical capital through reuse as collateral in layers like derivatives. In crises, capital shifts downward to safer assets like cash, and gold, reflecting a flight to stability. Exter’s pyramid highlights hidden financial risks, urging investors to look beyond balance sheets. Gold stands apart as an asset free from credit, government risks, and currency devaluation. With rising sovereign debt defaults and declining trust in public institutions, investors increasingly seek assets with no counterparty risk—gold, the ultimate antifragile asset.
When matching the four seasons of the business cycle with the four asset classes of the Permanent Browne Portfolio, investors should remember that cash is the preferred asset class during a deflationary bust due to its short-term maturity and the contractual nature of its value. Conversely, gold is the preferred asset during an inflationary bust, as it provides protection in environments where investor trust in the government diminishes.
This preference for gold over cash during an inflationary bust is evident from the CPI-adjusted performance of the four asset classes during the most recent inflationary bust in the US economy, spanning January 2022 to October 2023. During this period, still fresh in the minds of most investors, bonds and stocks were the asset classes to avoid at all costs. Gold, however, was the only asset class that provided inflation-adjusted protection for investors' wealth.
CPI adjusted return in USD of Gold (blue line); S&P 500 index (red line); Bloomberg US Ag Total Return Index (green line); Bloomberg US Treasury Bills 1-3 months Index (purple) between 31st January 2022 and 31st October 2023.
Investors know that the past four years and the turn into the 2020s have brought massive changes, not only in people's lifestyles but also in the weaponization of USD assets, which has had significant consequences on the economy and government spending. Apart from fuelling ongoing financial conflicts, this has been the source of structurally higher inflation. Looking at the performance of the four asset classes on a CPI-adjusted basis for U.S. investors, it should come as no surprise that gold and equities (e.g., the S&P 500 index) have offered not only higher but also positive inflation-adjusted returns, while contracts like cash and bonds have declined in value when adjusted for US CPI as the US business cycle swung from inflationary boom and bust since the start of this decade.
CPI adjusted return in USD of Gold (blue line); S&P 500 index (red line); Bloomberg US Ag Total Return Index (green line); Bloomberg US Treasury Bills 1-3 months Index (purple) since 31st December 2019.
From a longer time horizon, it becomes definitively clear to anyone who can read a chart that physical gold outperforms cash when the economy is in an inflationary mode, whether during an inflationary boom or an inflationary bust.
Upper Panel: S&P 500/Oil ratio (blue line); 84 months Moving Average of the S&P 500/Oil ratio (red line); Second Panel: Gold/Bond ratio (green line); 84 months Moving Average of the S&P Gold/Bond ratio (red line); Lower panel: Relative performance of Physical Gold to Bloomberg US Treasury Bill 1–3-month index (yellow line).
Upper Panel: S&P 500/Oil ratio (blue line); 84 months Moving Average of the S&P 500/Oil ratio (red line); Second Panel: Gold/Bond ratio (green line); 84 months Moving Average of the S&P Gold/Bond ratio (red line); Lower panel: Relative performance of Bloomberg US Ag Total Return Index to Bloomberg US Treasury Bill 1–3-month index (yellow line)
In summary, investors can conclude that, for asset allocators, cash is not always king; it reigns supreme only when the economy enters a deflationary bust, an environment the US has not experienced since the late 1990s and early 2000s and is unlikely to face soon. Anyone with a modicum of common sense can see that, despite the ‘Trumped’ propaganda spread by the elected 47th US president, the adoption of widespread tariffs will inevitably be inflationary and even stagflationary. This will likely push the US from the current inflationary boom into an inflationary bust sooner rather than later, following similar transitions in other major economies like the Eurozone and Japan.
If cash is not always king for asset allocators, the next question is: what about for stock pickers? In an environment where government spending among G7 countries has gone parabolic, and government debt and its refinancing have become major concerns for investors who understand where the real risks lie, many have yet to realize that corporations have been far more frugal in managing their balance sheets over the past decades. For those who fail to grasp that governments are living on borrowed time, a simple look at the evolution of US nominal GDP and public debt since 1993 is revealing. A key milestone occurred in December 2012, when US public debt surpassed nominal GDP for the first time. Since then, public debt has more than doubled, while nominal GDP has grown by less than 80% over the same period.
US Nominal GDP in nominal USD (blue line); US Public Debt in nominal USD (red line).
While the U.S. government has spent recklessly with little accountability, corporate America has managed its balance sheets far more prudently. The S&P 500’s net debt (Total Debt – Cash Equivalents) peaked in 2007 during the Global Financial Crisis and steadily declined until 2022, except during the 2020 COVID-19 lockdowns. Since 2022, net debt has risen slightly, likely due to increased investment in automation and AI to address inflationary pressures but remains below the peak of 2007 levels. Corporate America achieved this through a threefold increase in cash equivalents, while total debt grew by less than 8%. In contrast, US public debt has nearly quadrupled over the same period.
S&P 500 Cash Equivalents (blue histogram); Total Debt (red histogram); Net debt (Total Debt – Cash Equivalents) (green histogram).
This ability to generate significant cash while being prudent with debt has allowed corporate America to reduce its net debt-to-equity ratio to 65.0% on aggregate for the S&P 500 index as of the end of Q3 2024. This compares to a staggering 204% at the end of 2007, during the height of the Great Financial Crisis that led to bankruptcies like Lehman Brothers. If one assumes that nominal GDP represents the ‘equity’ created by the government, the U.S. government’s current net debt-to-equity ratio stands at approximately 123%. Any investor with a modicum of common sense can discern who is more likely to default in the foreseeable future and that’s why the once upon risk free asset (i.e. government bonds and cash) and not necessarily free of risks anymore.
S&P 500 Net debt to equity ratio since 1990.
Having cash on the balance sheet is important, but the ability to generate cash through a steady business model and redistribute it via dividends is a key indicator of corporate health. As of Q3 2024, the annualized free cash flow (FCF) for the S&P 500 reached a record high, surpassing the previous peak in 2021. Wall Street projects FCF to grow by 21% in 2025, following a 15% increase in 2024 and nearly doubling since 2014. Dividends are also expected to rise by 6% in 2025, having more than doubled between 2013 and 2024. As the U.S. economy faces challenging times ahead, investors should focus on sectors that are cash-rich and capable of generating positive FCF to ensure long-term resilience.
S&P 500 Free Cash Flow (blue histogram) Dividends (red histogram).
As the scenario of an inflationary bust is getting more traction, sector and stock picking will inevitably gain importance due to rising debt costs and increasing difficulties for corporates with a weaker business model to refinance their debt and grow their sales and earnings. In tis context, analyzing sector leverage can provide valuable insights for equity portfolio allocation. As of Q3 2024, three sectors within the S&P 500 have a net debt-to-equity ratio below 50%. Unsurprisingly, the notoriously cash-rich IT sector is the least leveraged, but some investors may be surprised to see Energy and Materials ranking as the second and third least leveraged sectors. Conversely, traditionally defensive sectors such as Utilities, Consumer Discretionary, and Consumer Staples are among the most leveraged, with net debt-to-equity ratios exceeding 100%.
Savvy investors know that in a world where geopolitics increasingly drives the business cycle, the best way to shield their wealth is by investing in a so-called Smart Defense Equity Portfolio, consisting of equal-weight investments in the IT, Energy, and Aerospace Defense sectors. When evaluating these sectors in terms of balance sheet quality, investors will note that the Aerospace and Defense sector is, unsurprisingly, more leveraged than both the S&P 500 index and the IT and Energy sectors.
At this point in the analysis, investors should have already understood that while cash is not always king for asset allocation, it is certainly key when selecting sectors within an equity allocation. This is especially important as the world is gradually shifting from an inflationary boom to an inflationary bust amid the threat of tariffs.
Digging deeper into stocks, as of the end of November 2024, 69 companies within the S&P 500 have a net cash balance sheet and have generated positive free cash flow (FCF) over the past 12 months. Not surprisingly, five out of the Magnificent Seven are part of this group. Over the past 24 years, the number of S&P 500 companies meeting this quantitative criterion has ranged from 61 in December 1999 to 131 in October 2005.
An investor who had invested $100 in an equal-weight portfolio of Net Cash & positive FCF companies over the past 25 years would have $765 as of the end of November 2024. Over the same period, those who had invested $100 in the S&P 500 would have $410, while $100 invested in the Smart Defence Equity portfolio, composed of one-third IT, one-third Energy, and one-third Aerospace Defence indices, would have grown to $1,885 by the end of November 2024.
Those with an inquisitive mindset would note that the Net Cash & + FCF portfolio began to deliver alpha against the S&P 500 starting in 2010, with an accelerating trend of outperformance at the beginning of 2020. However, it significantly underperformed from December 2021 to January 2023, a period previously characterized as an inflationary bust, before delivering another leg of outperformance during the past 22 months of the inflationary boom.
The main reason for the underperformance of this portfolio during an inflationary bust is likely that, since the 2020s, companies with net cash on their balance sheets and positive FCF generation have generally been found in the IT sector, which has historically been a sector to avoid during an inflationary bust. Meanwhile, the portfolio has been structurally underweighted in energy-producing sectors, such as Energy, which have historically performed well during difficult economic times such as an inflationary bust. In fact, between December 2021 and January 2023, the portfolio had no allocation to the Energy sector and nearly 30% allocated to the IT sector, along with over 10% in Consumer Discretionary.
As of the end of November 2024, the 69 stocks in the S&P 500 with a net cash position on their balance sheet and positive FCF generation over the past 12 months are primarily in the IT sector (33.3%), Financials (17%), Industrials (16.6%), and Consumer Discretionary (12.9%).
In a nutshell, if the worst-case scenario of a 'Trump Stagflation' materializes in 2025, that kind of sector allocation would not bode well for investors, based on the historical returns of energy-consuming sectors versus energy producers during previous inflationary busts.
Upper Panel: S&P 500/Oil ratio (blue line); 84 months Moving Average of the S&P 500/Oil ratio (red line); Second Panel: Gold/Bond ratio (green line); 84 months Moving Average of the S&P Gold/Bond ratio (red line); Third Panel: S&P 500 IT Index 12-monhs rate of change (yellow histogram); Fourth Panel: S&P 500 Energy index 12-months rate of change (purple histogram); Lower panel: Relative performance of S&P 500 IT Index to S&P 500 Energy index (orange line).
This brings us to the conclusion that, yes, cash is king in a deflationary bust and is likely to guide sector selection, especially when the economy shifts from an inflationary boom to an inflationary bust. However, relying solely on net cash positions and positive FCF generation for stock picking could lead to an over-allocation in sectors that have benefited from the recent inflationary boom, such as IT and Consumer Discretionary, while being underweight in sectors like Energy, which performs well during an inflationary bust, as seen in the US between December 2021 and January 2023. In this context, investors who can connect the dots and want to prepare for the worst-case scenario of a 'Trump Stagflation' should still conduct their due diligence in stock picking within the three sectors of the Smart Defence Equity Portfolio: IT, Energy, and Aerospace Defence. The Smart Defence Portfolio remains the best way for investors to reduce volatility in their equity asset allocation. However, investors should keep in mind that during an inflationary bust, they will need to reduce their equity allocation and increase their allocation to gold and other real assets.
Upper Panel: S&P 500/Oil ratio (blue line); 84 months Moving Average of the S&P 500/Oil ratio (red line); Middle Panel: Gold/Bond ratio (green line); 84 months Moving Average of the S&P Gold/Bond ratio (red line); Lower Panel: Relative Performance of Smart Defence to S&P 500 Index (yellow line).
Investors should also never forget that, in the worst-case scenario of an inflationary bust, gold, not government bonds, is the antifragile asset to hold. Among equities, investors will need to shift from energy-consuming sectors like IT to energy-producing sectors like oil and gas. This shift will occur in an environment where investors must increasingly prioritize the Return OF Capital over the Return ON Capital.
Read more and discover how to position your portfolio here: https://themacrobutler.substack.com/p/cash-king-or-catch
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