Over time, the absolute valuation of assets depends primarily on the demand for money within the market portfolio, relative to other assets.
Using the same asset allocation benchmarks as the previous analysis, the following looks at the impact of changing preferences for holding money within the market portfolio and annual increases in broad money supply growth.
We assume that preferred cash holdings start at 8% of the portfolio, at the peak of the market and economic cycle, and move up to 12% at the nadir of the market and economic cycle, recovering to 9% towards the next market and economic peak. In this analysis a 10% cash allocation is assumed to be an average or equilibrium allocation.
The dark red line on chart 1 represents the real return (after 3% per annum inflation) on the equity component, and the blue the nominal return. Money supply is growing by 7% a year; the market valuation, at any point in time, adjusts for this increase to bring back the allocation to money within the portfolio to the appropriate level (be it 8%, 9%, 10%, 11%, 12% etc).
The chart does not show the impact of a decline in money supply or stagnant money supply growth – something which could happen following an asset price bubble -, nor does it show the impact of higher inflation and lower growth (stagflation) on real earnings growth and its valuation.
What it does illustrate, is the impact of changes in cash holding preferences and money supply growth on market performance. It retranslates the market timing imperative into one that should be focussed on protecting the ability of a portfolio to meet financial liabilities over time frames sufficient to cover the risk of events that change the demand for money within the market portfolio.
Chart 2 shows the valuation perspective – the long term risk/return profile of asset classes at different stages of the market and economic cycle. This is the market risk of buying at various stages of the market and economic cycle as represented by changes in relative cash holdings. Those who purchase at low portfolio cash allocations depend on future cycles exhibiting similar extreme allocations.
Chart 3 shows the impact on return to investors of different starting positions. The dotted red and blue lines show the respective capital index positions of equities if the cash allocation remained at 10% instead of moving back to an excess of 8% (blue line) and 9% (red line). In other words, market peaks are extreme positions; where these peaks are exacerbated by excess, asset focussed, money supply growth, they are also points that cannot be supported by real consumption, production, savings and investment relationships – for explanation see sections 3 and 4.
The risks noted in chart 3, for the blue and the red lines, assuming that money supply growth is not affected, are not fundamentally economic risks, but risks caused by changes in portfolio cash holding preferences. Since extremes in market valuations are often associated with excess asset focussed money supply growth, periods associated with asset price booms would see greater risks to the returns depicted in graphs 2 and 3.