Cash is King – Are you recession ready?

If you have ever been through a recession (2008?) or financial hardships, then you know that Cash is King. But then again, maybe not! The human mind is a funny thing. It fools smart people into discounting unpleasant times and tends to make choices that favor easier times at the cost of hidden risks. Nassim Taleb would argue that this attitude in decision making, which favors instant gratification, leads to creating fragile ecosystems rather than Antifragile ones.

To understand the importance of cash, consider a company that has large accounts receivables on its balance sheet, this would increase equity (and market cap), but the company could still be short of cash to pay for its daily operating expenses (such as raw materials and salaries). Unless the company could quickly convert its accounts receivables into cash (perhaps through bill discounting), the company could go bankrupt despite having a positive net worth. And that is simply why cash is king!

Now let’s evaluate how safe your money is and whether you really will have it when you need it the most by taking a look at the global capital markets and banking systems.

The global Fund industry is estimated at $40.36 Trillion, to put that number in perspective, the Gross World Product in 2014 was estimated at $ 77.87 Trillion. If this comes as a surprise to you, then you are probably wondering how is it even possible to have so much money invested through funds alone and yet have so much more in supply around you, invested in real estate, infrastructure, proprietary businesses, e.t.c. The answer lies in Fractional-reserve banking – which is the modern form of banking practiced in most countries for over a century.

Here’s a short story to illustrate how the Fractional-reserve banking system works. Consider a village which has among other people a butcher, a brewer, a baker and a banker. The butcher wants to buy a goat so he borrows $10 from the banker to buy a goat from the market. The person who sold him the goat deposits the $10 received from the sale in his bank account with the banker. The banker assumes that the $10 will not be withdrawn right away and so lends it to the brewer who needs it to buy seed. The person who sold seed to the brewer deposits the $10 in his bank account with the banker. The banker again assumes that this deposit of $10 will also not be withdrawn right away and so lends it to the baker who requires it to buy flour. The person who sold flour to the baker deposits the $10 in his bank account with the banker. Now the banker has received the original $10 back again.

In our short story, the banker has tripled his assets and liabilities while he still has his original $10 bill. The sellers of goods assume they have $30 in cash, available to them whenever they need it, so they go ahead and buy other goods and services. This cycle goes on and on with inflation as a side-effect of the increasing money-supply. When borrowers fear that there might not be further growth, they start paying off their loans and this starts a deflationary cycle. The problem of course comes when the interest on all the loans can not be paid causing debt overhang and bankruptcies, as it did in 2008.

At the beginning of 2017 US had $3 Trillion in base money (the ten-dollar bill in our story) which supports an estimated $65 Trillion in unreserved credit.

Increasing interest rates in the US has already started driving global stock markets into caution. Our algorithms started noticing the Trump bull rally in equities fade around the 9th of March, this coincided with a sharp fall in the M1 Money Multiplier prompting us to write this post. So, are we at the cusp of a recession? Honestly, we don’t know – we don’t try to predict the future. However, what we can tell you is that if you have invested in Long only investments such as mutual funds or ETFs, then now (while earnings multiple is still significantly higher than historic average) is probably a good time to hedge them; Or, if you are over leveraged on your investments, then consider foreclosing your loans to avoid bankruptcy.