The Cash on the Sidelines Myth
Although the returns aren’t bitcoin-like, the good old stock market is up 19 percent this year, with the S&P 500 closing at fresh all-time highs almost daily. And despite sky-high valuations, many pundits believe there is room to go higher.
One of the most common arguments stock investors use is that “there is a lot of cash on the sidelines” that doesn’t yield anything and could be more gainfully invested in the stock market.
“With $2.65 trillion still in money-market funds, there would have to be a lot more evidence before cash flows could point to a market top,” wrote Jeff Cox earlier in the year for CNBC.
“It’s just the beginning of money coming in. That’s a large inflow, but certainly not to the point of alarm. I would want to see that for five or six quarters in a row before I would get worried,” said Keith Springer, president of Springer Financial Advisory, to CNBC, commenting on a $75 billion move from money-market funds into stocks in February this year.
And there are data to support this argument. According to the Federal Reserve, households, nonprofits, and nonfinancial, noncorporate businesses held more than $12.68 trillion in cash as defined by checkable deposits and currency in the second quarter of 2017, a trifle below the all-time high of $12.74 trillion from the first quarter.
So this record cash on the sidelines, whether it’s in brokerage accounts or money-market funds, could be used to invest in stocks, which are producing solid returns. And the language used in the argument implies that if people were smart enough to use that cash to buy stocks, then cash balances would fall and stock prices would go up higher.
There is only one problem with this argument: The cash doesn’t go away.
People have indeed been using the “cash on the sidelines” to buy stocks and plenty of them, but buying stocks doesn’t extinguish cash assets. The money just goes from the buyer to the seller and then sits on the sidelines in his account.
So instead of looking at the absolute amount of money that’s held in cash, one needs to look at the relative amounts. Because it is true that the frequent changing of hands of that cash and the buying of stocks does bid up the price of the stock market. People value owning stocks more than owning that cash. So the stock buyer has to make a better offer to the seller who may say, “What do I want with all this idle cash? Give me more of it to part with my dear stocks.”
The adjustment or the valuation of “cash on the sidelines” works through stock prices. As prices move up and cash prices stay the same—it is cash, after all—it naturally becomes a smaller part of the asset allocation mix of households and companies.
Research firm Gerring Capital Partners calculated this mix based on Federal Reserve data and found that stocks make up 35 percent of the nonfinancial private sector’s wealth, close to the all-time high in 1999 of 40 percent. Cash only makes up 17 percent of the total aggregate portfolio allocation, a far cry from the high seen in the beginning of the 1980s of 35 percent and pretty close to the all-time low of 15 percent from 2000.
Another way to look at this relative dynamic is to calculate the total market value of the S&P 500 and compare it to the total value of money-market funds. According to the website SentimenTrader, this ratio stood at 4.62 in June, an all-time high.
So investors have been devaluing their cash holdings by bidding up stocks. But because the cash just changes hands, there will always be cash on the sidelines, unless we were to experience another 2008 with an outright debt deflation. The equity-to-money-market ratio bottomed at 1 in late 2009.
No Cash Left
In fact, if we start looking in some other places, we find that there isn’t that much stock-ready cash at all. Mutual fund cash holdings, for example—and these are the people who pull the trigger and buy stocks—is at an all-time low of 3.3 percent, after reaching an intermediate high of 6 percent just after the last financial crisis.
Other trigger-happy investors include people with brokerage accounts and money in them. But margin debt, or borrowed money to buy stocks on the New York Stock Exchange, keeps smashing all-time highs at the same pace as the S&P 500, closing in on $600 billion. Buying stocks with debt works if prices keep rising, but the fact that people need to borrow record amounts to sustain this rally doesn’t fit the idle cash narrative.
This does not mean that the money-market holdings can’t change hands a few more times for higher stock prices until the fundamental drivers of the rally have exhausted themselves. So as long as interest rates don’t rise too high, earnings keep growing, and we don’t experience a recession, stocks may well continue to go higher.
Cash on the sidelines, however, has nothing to do with this.