Monday, May 18, 2009

The Fallacy of "Cash on the Sidelines"

The concept of "cash on the sidelines" is, in my opinion, one of the simplest and yet most mis-understood concepts in capital markets today. I give John Hussman a gold star for eloquently and thoroughly explaining the fallacy (again - he's tried before) in his latest missive: "The Destructive Implications of the Bailouts- Understanding Equilibrium." A simply Google query on "cash on the sidelines" will unleash a torrent of mainstream media outlets and blogs who think they've found the holy grail of equity upside proclaiming that the stock market is bound to rise rapidly, because there is so much "cash on the sidelines" right now. Let's explain why this theory is bunk by looking at Hussman's explanation (emphasis mine) as it relates to the current crisis - where the Fed has been pumping liquidity (money) into the system at a rapid rate, and the Treasury has been flooding the market with new issuance:

The second fact is that as a result of more than a trillion dollars of new issuance of Treasury securities with relatively short durations, it is a tautology that there is a mountain of what is mistakenly viewed as “cash on the sidelines” invested in these securities. This mountain of “sideline cash” exists and must continue to exist as long as these additional government securities remain outstanding. It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered. The analysts and financial news reporters who observe this enormous swamp of short-term money market securities, and talk about “cash on the sidelines” as if it is spendable in aggregate immediately reveal themselves to be unaware of the concept of equilibrium and of the nature of secondary markets (where there must be a buyer for every security sold, and a seller for every security bought).

If you sell your stocks or bonds or money market securities, they don't cease to exist. Somebody else has to purchase them. Somebody else has to hold them. As I've said numerous times, if Ricky wants to sell his money market funds and buy stocks, then his money market fund has to sell money market securities to Nicky, whose cash goes to Ricky, who uses the cash to buy stocks from Mickey. In the end, the cash that was held by Nicky is now held by Mickey. The money market securities that were previously held by Ricky are now held by Nicky. And the stocks that were once held by Mickey are now held by Ricky. There is exactly as much “money on the sidelines” after these transactions as there was before. Money doesn't go into or out of the stock market – it goes through it. Prices don't move because supply exceeds demand or demand exceeds supply. In equilibrium, the two are identical because that's exactly what a trade is. Prices move because the buyer is more eager than the seller, or vice versa.

Now, don't get confused by Ricky, Nicky and Mickey - the point is simple: every time someone buys a stock (spending cash), someone else sells it (raising cash). The "cash on the sidelines" doesn't change. You can add more people in the middle of the chain (Dicky, perhaps) and more asset classes (commodities, bonds options) - but that will never change the fact that in each trade along our hypothetical chain, each person buys an asset from someone else, resulting in a cash debit for the buyer, and an offsetting cash credit for the seller.
If you're looking for another explanation of this concept, check out Mish's piece from November, 2008, titled "Sideline Cash Theory Revisited."


Sumit said...

Hi KD,

My understanding of your writ is that even though there may be money in the system, that doesn't mean it will rally the share market, as many other factors goes into driving the share market. Am I correct?


Kid Dynamite said...

well sumit, what you wrote is true, but the point of this post is that "Cash" has really already been spent. money market funds own debt. if you sell your money market fund, someone else buys it - the net "cash" doesn't change...