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Investment Update: Corporate Cash and the Great Rotation

September 2013

Jeffrey Mortimer, CFA

Director of Investment Strategy, BNY Mellon Wealth Management

As a kid, I was a spender. I would hold onto my money only long enough to purchase whatever I had been saving for, whether it was a baseball glove or a bike. My sister was the opposite. The joke in my family is that my sister still has every penny she received for her 10th birthday nearly 40 years ago. Investors can look at many different variables to evaluate what the markets may do going forward. Earnings, valuations and global economic themes can all shed light on potential stock and bond performance. In today's environment, however, one can also look at the very same metric that was so highly valued by my kid sister: cash. In this case, I'm referring to the corporate variety.

While U.S. stocks have more than rebounded from their recessionary lows as the economy has strengthened, businesses still are holding significant cash on their balance sheets. They are doing it for far different reasons than my sister, motivated not just by a desire to save but by the challenging economic environment that has unfolded since the financial crisis. Excess corporate cash is an interesting data point because it sheds light on some of today's emerging investment opportunities. It also provides insight on a looming market transition — the Great Rotation from bonds to stocks.

Why Companies are Holding Cash

Today's market environment has certainly given companies plenty of reasons to remain cautious and hold cash on the books. The Great Recession is still top of mind for many firms that were caught short of cash when credit dried up.

Staying liquid, especially post-crisis, provides companies with the flexibility to weather a short-term storm without having to go to the markets or lending institutions to meet day-to-day obligations.

Companies also are watching their dollars as they brace for heightened volatility given expectations of the end to the Federal Reserve's Quantitative Easing program. An expected change in Fed policy has caused bond prices to fall sharply this year. Rising taxes and the implementation of new healthcare legislation are other impending costs on the horizon. Europe is only now beginning to come out of recession, and emerging markets have struggled in 2013, which also has added to the wall of worry even as stocks grind higher.

Given this backdrop of uncertainty, many corporations are holding cash (as a percentage of overall assets) at significantly higher levels than they carried in the mid-1990s. Cash levels in the 1990s are a good benchmark because that period may have been the last time markets could be considered "normal," before the seismic market distortions of the Internet boom and the Great Recession. For example, as outlined in Exhibit 1, more than half of the sectors of the S&P 500 have nearly doubled or tripled their excess cash weightings since that time period. Industrials, though a smaller overall sector, have more than tripled their cash on the books. The current cash weightings for technology and health care are especially large, representing 27.3% and 17.1% of assets, respectively. However, the higher tech weighting is likely driven by the large liquid positions of a few bellwether names, such as Apple's $42.5 billion in cash and short-term investments.

Exhibit 1 // Corporate Cash as a Percentage of Assets

S&P 500 Sector 1995 2013 Change
Industrials 3.4% 10.3% 202.9%
Telecommunications 1.6% 3.8% 137.5%
Materials 4.0% 8.5% 112.5%
Consumer Discretionary 5.0% 9.8% 96.0%
Consumer Staples 4.0% 7.8% 95.0%
Information Technology 14.2% 27.3% 92.3%
Health Care 10.6% 17.1% 61.3%
S&P 500 9.0% 13.1% 45.6%
Utilities 1.2% 1.5% 25.0%
Energy 4.2% 4.9% 16.7%
Financials 14.0% 14.4% 2.9%

Source: StrategasRP. As of 3/31/13.

Investing Implications of Excess Cash

All firms carry some cash on their balance sheets. Companies typically recycle "excess" cash back into the economy in the form of dividends or share buybacks, capital expenditures, and mergers and acquisitions (M&A). The pace of cash going back into the economy post recession has been muted thus far, no doubt because of the challenges of today's environment. But we expect all of the following trends will gain momentum in the coming months as companies develop more confidence in the recovery, with positive implications for investors.

Dividends — Dividend payout ratios are near 135-year lows, as companies have held onto their cash. Even with the low payout levels and the sharp rise in interest rates in 2013, 23% of the S&P 500 companies still have a higher yield than the 10-year Treasury. Cash from operating activities continues to be strong. We expect payouts and dividend yields to increase as companies become more comfortable deploying their cash.

Share buybacks — By purchasing stock in the open market, companies can reduce the total number of shares outstanding, thus increasing earnings-per-share and improving their stock prices. Many companies across multiple industries have said they intend to buy back stock.

Capital expenditures — Businesses have slowly begun to use cash to buy new equipment, upgrade technology and expand operations. When firms take steps to shore up their long-term operations it will be good for the economy and stock market as money moves from unproductive "storage" to a much higher and better use.

M&A activity — It is only a matter of time until deal activity begins to heat up. Already, we are seeing signs of life. For example, in early September, Verizon Communications Inc. and Vodafone announced a $130 billion deal in which Vodafone would sell its stake in the wireless business jointly owned by both companies. The combination is a sign of rapid consolidation and change in the telecom industry. Around the same time, Microsoft announced plans to acquire for $7.1 billion almost all of Nokia's devices and services business, license Nokia's patents and mapping services, with far-reaching implications for the software giant. M&A activity provides an excellent backdrop for the market, as it signals that buyers are willing and able to pay a (much) higher price than the stock is trading for in the open market. Often, the stock of the acquired company rises, as do the stocks of competitors which are quickly seen as takeover targets as well.

Positioning for What Comes Next: The Great Rotation

While corporations are preparing to put their cash to work, about $2.6 trillion is sitting in money market funds, including about $1.7 trillion in institutional cash. This is down from a height of $3.8 trillion in 2008. Many individual investors have exhibited similar signs of cautious behavior, staying in bonds or cash as the stock market has gained more than 163% from its recessionary lows.

From 2007 to 2012, investors funneled more than $1.2 trillion into bonds, while pulling out nearly $600 billion from equities. The steam train into bonds continued until June, when bond losses caused by rising rates triggered steep outflows. Yet the roughly $100 billion in bond outflows over the summer represent a tiny fraction of overall bond holdings.

Now, however, with rates poised to rise in the coming years, the tide will likely move out of bonds with a vengeance. Investors who have been stubbornly holding onto bonds will begin to move back into equities in a "Great Rotation" from bonds to stocks.

This rotation is in the very early stages. As worry fades, and it inevitably will, the next sentiment that will begin to rise in the markets will be greed. Investors will look at the equity market, and realize they have not participated to the extent that they should have. They will begin buying stocks, leaning into the market in an attempt to obtain the returns that have passed them by. Investors did the same thing in the late 1990s and even in 2007.

Summary

Cash is the manifestation of skittishness and skepticism — among both corporations and investors. It serves as a sign that all is not well in the minds of those who allocate money among risky and non-risky assets.

Certainly, we wouldn't recommend that anyone buy or sell on just one piece of data, but the cash buffer provides yet another positive backdrop for the equity markets over the intermediate and longer term. It is yet another reason why we think this bull market may have further to go. History is littered with investors who pile onto one side of a trade, sometimes for years. These trades tend to end badly. We believe the same thing has already happened in today's environment: Stock and bond markets are both up substantially from the March 2009 bottom, leaving those investors still holding cash far behind.

Although corporate cash has begun to move back into the market and some investors are easing into equities, it seems obvious that more activity will pick up as sentiment improves. When the flood gates open, it will be the next phase in this bull market's history. Even my sister, who is still a penny pincher, is beginning to move more of her portfolio into equities. Investors who are sitting on the sidelines may well want to do the same.

Each month, for clients and associates of BNY Mellon Wealth Management, we provide commentary on the stock markets and the economy through the Investment Update.

BNY Mellon Wealth Management is a nationally recognized leader in investment management, wealth and estate planning, and private banking and finance capabilities to financially successful individuals and families, their family offices and business enterprises, charitable giving programs, and endowments and foundations. Our clients benefit from our wealth management excellence and our commitment to adapting our organization's strengths to their unique circumstances.

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09/2013