Why Holding Cash is a Bad Idea

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Standard & Poor's reported this week that the non-financial companies in the S&P 500 have accumulated a record-high $837 billion in cash as of March 31, 2010, the latest quarterly accounting period available. That's up 25.8% from a year earlier and up 221% from the end of 1999. General Electric leads the way with $116 billion in cash, while three tech giants Cisco Systems (NASDAQ: CSC ), Microsoft (NASDAQ: MSFT ) and Google Inc. (NASDAQ: GOOG ) each have over $30 billion in cash, with Apple Inc. (NASDAQ: AAPL ) at $24 billion.

But that's just the S&P 500. According to the Federal Reserve's first-quarter flow-of-funds data, released last month, U.S. corporations now have more than twice that amount, $1.8 trillion in cash. This cash hoard is growing rapidly. So far, the S&P 500′s second-quarter earnings are up 21% over the same quarter last year - the fifth straight double-digit year-over-year quarterly gain.

There are several uses for that new money, all of them positive, but they aren't happening much (yet): Companies can (1) buy back stock, (2) redeem bonds, (3) hire new people, (4) raise their dividend, (5) acquire (or merge with) other companies or (6) expand, by building new facilities or buying new capital equipment. These cash usages are all on the rise, slowly, but none of these positive cash outlets are increasing anywhere near the level of aggregate earnings growth.

Take dividends for example: So far in 2010, 142 of the S&P 500 have boosted their dividends, while just one has lowered its dividend. Last year at this time, just 93 had raised their dividends and 61 had lowered their payout. Ten of the S&P 500 firms have initiated dividends this year vs. just one last year.

But net dividend growth is microscopic. Companies paid $50.4 billion dividends in the second quarter, up 5.9% from a year ago and up 2.3% from the first quarter, well below the $67 billion paid in late 2007, and well below their 21% earnings growth. With taxes on dividends set to rise in 2011, we're not likely to see dividend growth next year, barring a revolution in Congress.

Most companies are sitting on near-zero-interest cash - as are many investors and mutual fund managers. Why accept such low yields? Many analysts theorize that near-zero interest income in the bank is better than taking any kind of risk. After all, what would you do with your cash after the current Fed Chairman says that the economic recovery is now "unusually uncertain?" With the scars of 2008 still fresh, corporate managers are hoarding cash for a 2008-style "rainy day."

Short-term Interest Rates Going Lower

The widespread demand for no-risk cash is pushing short-term interest rates down further than anyone thought possible just a few years ago. This week, the federal government sold over $100 billion in Treasury securities, whose rates set new lows: First on the auction block, $38 billion in two-year notes came in at a record low yield of just 0.665%, down from the previous record low of 0.738%, set in June. The Treasury then sold $37 billion in five-year notes on Wednesday, netting 1.796%, followed by $29 billion in 7-year notes today on Thursday, yielding 2.394%

The short end of the Treasury yield curve is now dominated by numbers starting with ZERO:

1-month = 0.15% 3-months = 0.15% 6-months = 0.20% 1-year = 0.30% 2-years = 0.61% 3-years = 0.95%

Source: U.S. Treasury; rates as of July 28, 2010

In the banking sector, six-month Jumbo CD yields (on $95,000 or more) fell to just 0.41%, while smaller CDs yielded a whisker less, 0.38%. Bank customers must go out two years to get just 1% (1.03%), and they must now tie up their cash five years to approach 2% (1.93% for 5-year CDs).

Risks in Holding Cash

Cash is considered a no-risk investment, but there's no such thing as a risk-free investment. There is only some "controlled" risk. Cash in the bank has some invisible termites eating away profits:

1 - Lower interest rates: Just when you think rates can't go lower, they go lower. Elderly couples who retired five years ago on expectations of 3% returns on their $1 million in cash suffered a 90% income haircut from $30,000 per year (3%) down to $3,000 (0.3%). That's a big risk.

2 - Higher taxes: Next year's tax on dividends is slated to rise to 20% (vs. 15% this year), while top tax rates on interest, including bonds and CDs, reverts to 39.6%. This adds insult to injury.

3 - Currency risk: While any income seems positive, the U.S. dollar has fallen sharply over the last decade. Recently, the dollar fell to $1.30 per euro, meaning that your income and capital gains would be far more lucrative if held in Euros or other currencies rather than U.S. dollars.

4 - Inflation risk: To earn more than 2%, you need to tie your money up for five years or more (in a CD) or buy a 7-year (or longer) Treasury bond. Who can predict inflation 5-7 years out?

5 - Bank failures: There were absolutely NO bank failures for a 31-month period from June 25, 2004 to February 2, 2007. In 2007, there were only three bank failures. Then, the problem grew.

Just look at the recent history of Bank Failures for proof:

2003: 3 2004: 4 2005: None 2006: None 2007: 3 2008: 25 2009: 140 2010: 183 (the projected pace for this year, according to the FDIC)

Bank failures this year are on a pace to be the most since 1991 (when 271 failed). You seldom hear about these bank failures, since most failed banks have under $1 billion in deposits. But 103 U.S. banks have failed through July 23 of this year. Such announcements are usually made Friday evenings. (last Friday, five more were shuttered, bringing the total so far this year to 108).

Here are the totals over the first three Fridays in July before that:

July 9 - 4 bank failures, $1.03 trillion in deposits July 16 - 6 banks, 1.85 trillion in deposits July 23 - 7 banks, 2.02 trillion in deposits

It's Friday afternoon: Do you know where your money is? I don't intend to scare you. While it's true that the FDIC protects bank deposits (within statutory limits), the FDIC's slush fund for bailing out banks is running low. It will likely require some extra funding next year. More to the point, the FDIC cannot protect you from high tax rates, low returns, devalued dollars and higher inflation - the many risks that stem from the same government that "protects" your cash hoard.

Bottom line, due to low returns and hidden risks, investors frustrated with low interest rates will likely turn to stocks soon, especially if we see more predictability and stability in Congress after November. Corporations will also likely turn some of their cash into more productive uses after they see the end of legislative fever in Washington, and a return to relative gridlock in 2011.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: CSC

Louis Navellier

Louis Navellier

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