FYI | Oct 29 2009
By Greg Peel
The argument is simple. From the US perspective, trillions of dollars worth of stock market investments were sold in 2008 as a tidal wave of risk aversion swamped the world. In some cases that money found its way into gold as a safe store of wealth, or into US Treasury bonds as a “riskless”, albeit low interest-paying, investment, or simply into cash. In this case cash is not dollar bills under the mattress, but cash management trust accounts.
The idea is that investors “parked” their money in cash to avoid any further losses in stocks and other investments, with the intention that one day, when things looked rosier, the money would be redeployed. Clearly the 60% stock market rally from March provides evidence of such redeployment.
That rally has been sudden, sharp, and for the most part driven by relatively low volumes. One argument to justify low volumes is that not everyone was convinced in March, nor even in April, but by May the rush had begun from those capitulating on a basis of “fear of missing out”, or the so-called “FOMO” trade. Aside from individual investors, FOMO has been driven by fund managers who need to show they have joined the rally to show positive returns. To not show positive returns would be to lose investors.
There was a stumble in July, but only a 7% correction ensued. While many were expecting a more significant pull-back, a lack thereof was justifiable in reference to “cash on the sidelines”. There were still those who missed the jump, and did not have the gumption to chase the rally. They were now looking for any opportunity to get in on a dip in the market. So extensive was this “cash on the sidelines”, the argument goes, any real dip was impossible because it had become a case of any dip will do. And so we forged ever higher.
Here at the top of the second leg of the rally, the same argument is still being applied. Never mind that 60% rallies don’t happen every year, nor even every decade, and never mind that stock prices never go up simply in a straight line. There is still, apparently, bucket loads of “cash on the sidelines” still waiting to be deployed, albeit late in the game.
Indeed, the number bandied around is US$3 trillion.
Goldman Sachs posted a report today that challenges the argument. In reality, what Goldmans has said is really stating the bleeding obvious. The analysts simply argue that just because there is US$3 trillion sitting in cash management trust accounts, there is no logical reason why all of that must be waiting to become equity investments. It could equally be waiting to buy bonds, or property, or any thing under the sun, quite frankly. Or maybe that cash is right now simply still feeling quite cosy, thank you very much.
An interesting statistic revealed last week is that in the nine months to September, net domestic US equity flows were about zero. That just means for every dollar value of stock bought, the same dollar value of stock has been sold in 2009 to date. That might seem strange, given the S&P 500 rallied 65% from its lows, but then it’s only up 18% for 2009 – on low volume.
In the meantime, observers have remained slightly bemused as to why US Treasury bond prices have remained at high levels over the period, given bond prices and stock prices are meant to move conversely as bond yields fight against dividend yields. What’s more, extreme debt issuance from the US Treasury should have diluted interest in buying US bonds, so both demand and supply point to lower bond prices (higher yields). But in actual fact, the ten-year US Treasury note entered 2009 with a yield of about 2.4% and is now 3.4% – a drop in price of 42%.
But with a net S&P 500 gain of 18% in 2009, one might assume domestic 2009 equity flows to be at least positive. That they are zero could mean one of two things. Either there is still a great deal of money that’s completely missed the rally in stocks but still wants to be in stocks at the right level, or it could mean US investors have now been once bitten and are twice shy. Maybe that money simply does not want to be in stocks at all.
In the bull market bubble of the past few years, Americans were very overweight equity investments. And why not? Stocks were providing stellar returns. But that has all ended in tears, and there’s a very good chance chastened investors will now look to a more conservative balance of risk-reward from here on, represented by diversification across, stocks, commodities, bonds and, of course, cash.
Another factor to consider is the role that leverage played in the bull market to 2007. Margin lending was all the rage, allowing investors to put up only US$1000 to buy a US$10,000 portfolio, for example. This had a multiplier effect on stock price movements, just as surely as mortgage lending multiplies bank deposits. But not only are chastened (or bankrupt) investors now reluctant to risk dangerous leverage again, neither are margin lenders keen to lend too aggressively. The effect is less money making its way into stocks, and less money likely to make its way into stocks.
And is there really that much “cash on the sidelines” anyway?
The following graph is available at www.safehaven.com. It compares the March trough and subsequent rally in the S&P 500 (blue line) with the level of investment in the Rydex Money Market Fund (red line). One cash management fund is not totally representative, but this large fund is considered a sufficiently representative sample.
One might consider the Rydex a negative, or contrarian indicator. Note that cash levels were at their highest at the trough in the S&P. This was the point at which risk aversion reached its peak and the turn was on. The 7% correction in July followed the low point in cash, and thereafter the S&P lopes its way ever higher with cash levels remaining in a range. Right now, as the S&P tips over, cash levels are at their lowest for the period.
In other words, this graph suggests the market tips over when there’s actually not enough cash on the sidelines. If true to form, money will now be rushing out of stocks and into cash until cash becomes “overbought” once more, and then the S&P turns around once more. What we see in this graph is money running in and out of cash like the tide. What we don’t see is any indication cash levels have been steadily diminishing with the stock market rally, with plenty more to be yet deployed.
Cash is not simply being converted into stocks as the stock market trends higher. It is bouncing around between the trend lines of “fear” and greed” as the rally plays out. The connection is tenuous, beyond cash management trusts being used as a stock trading “bank account”.
The whole “cash on the sidelines” argument is tenuous. Indeed, it has been noted that if one reads the newspapers around the time of the Great Depression, in which the US stock market enjoyed a similar rally to the one we’re having now post 1929, much was made of “cash on the sidelines”. The market then fell 80%.
Not that I am suggesting this will happen again. And any correction may well find late buying. But one can’t necessarily take “cash on the sidelines” as a guarantee that stocks are its only destination.
