Where Else are Investors Going to Go?

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

... asked a well-known equity analyst on CNBC last week, implying that the question was so rhetorical as to need no further argument supporting a bullish outlook for the stock market.

Few arguments make me wince as reliably as statements that disregard the concept of equilibrium. The fact is that stock markets don't go down because investors withdraw money from the stock market and put it elsewhere, and they don't advance because investors take money from elsewhere and put it "into" stocks. Bear markets occur without any net removal or redeployment of funds out of the stock market. Likewise, bull markets do not rely on "net inflow" of funds from investors. A moment's reflection should make it obvious that for every person selling stock and taking money "out of the market" stands a buyer of the stock who is putting that exact same number of dollars "into the market." The whole concept of "money flow" is nothing but an oversight of this fact.

Except for new issuance of stock, money never flows "into" the stock market - merely through it. Even in new issuance, what's really going on is that new savings - new income left over after consumption and taxes - flows directly from individuals to the corporations issuing the stock, in order to finance new investment. I say "new" savings because if the investor gets the funds to buy the newly issued stock by selling other securities, some other investor would have had to buy those securities with their savings, and that argument can be repeated indefinitely until the only source of the funds, at bottom, must be somebody who earned new income and didn't spend it. So stock issuance represents a transfer of income saved by individuals to corporations, who then deploy those savings by investing in factories, equipment, and other assets. As always, savings equal investment in equilibrium.

Similarly, except for buyouts, takeovers and net repurchases of stock, money doesn't flow "out" of the stock market when an investors sells. (I say "net" repurchases because the majority of stock repurchases made by corporations are executed merely to offset the dilution that occurs when corporations grant stock and options as compensation. So net repurchases represent a transfer of income saved by corporations to individuals who then deploy those savings.)

The idea that bear markets don't require a withdrawal of funds from the stock market, and that bull markets don't require an "inflow" of funds, can be difficult to accept at first. There's a natural tendency to think of the stock market as one big "representative" investor, and that this huge Gulliver allocates his pool of savings across stocks, bonds, T-bills and so forth, driving prices up and down as those allocations change. But that's not the way markets work. The whole concept of a secondary market (a market for securities that have been issued) is that all issued securities must be held by someone - when buyers meet sellers, the money held by the buyer goes into the hands of the seller, and the share held by the seller goes into the hands of the buyer. There is exactly the same number of shares outstanding after the transaction as before, and exactly the same amount of "money on the sidelines."

Mickey, Nicky and Ricky

The example I used to give to my former students is this. Suppose Mickey wants to buy stocks, and sells some money market funds out of his portfolio to pay for them. Well, in order to get the cash to give to Mickey, the money fund has to sell some of its commercial paper holdings to Nicky, who buys the commercial paper with her cash, which then goes to Mickey, who uses the cash to buy stocks from Ricky. In the end, the cash that Nicky used to hold "on the sidelines" is now held by Ricky, while the commercial paper held by Mickey (via the money market fund) is now held by Nicky, and the stocks held by Ricky are now held by Mickey. Ownership claims have changed, but there is exactly the same amount of cash, money market securities, and stock shares in existence after these transactions as before them. Yes, prices may have changed depending on who was most eager to do those transactions, but there was no net flow of money into or out of the stock market.

Presumably, if Mickey was the most eager trader, and had to give an incentive to other traders to induce them to change their existing portfolios, we might observe, for example, the price of commercial paper being pressured down and the price of stocks to be pressured up, so Mickey would have found himself having to give up more of his money market funds to buy the stock than if other traders were more eager or prices had remained fixed. But any price changes that occur don't happen because of net money flow into or out of their respective markets - they happen because one trader is more eager than another, and so have to provide an incentive for the other trader to enter the transaction.

And there's the point. Bear markets don't happen because stock market investors decide, in masse, to go into bonds, or money market funds, or other vehicles. They don't happen because there is more selling than buying (which can't happen in equilibrium), or more money going out than coming in. Rather, they happen because, at prevailing prices, sellers are more eager to liquidate stock than buyers are to purchase stock, so prices have to fall enough so that, at the new prices, the amount of stock that sellers wish to liquidate is exactly equal to the amount of stock that buyers wish to purchase.

In short, investors don't have to go anywhere in aggregate in order for stock prices to decline (or advance, for that matter). Money doesn't have to flow "out of" one vehicle and "into" another. All that's required for stock prices to move is a change in the willingness of investors to hold those stocks at their existing prices. If existing holders are less willing to hold stocks, and potential buyers are less willing to own them, then stock prices will fall to a new price where the amount of stock supplied by potential sellers is exactly the same as the amount of stock demanded by potential buyers. One share, traded between the single most willing seller and the single most willing buyer, at a price agreeable to the both of them, can be the basis for a billion-dollar change in the market value of a stock (market value is nothing more than shares outstanding times the prevailing price).

Market value isn't like some balloon that inflates when money flows into a stock and deflates when money flows out. Rather, it's a like closed box of blocks, where changes in the value of a single block (one share of the stock) - whether or not any blocks are even traded - determines the value of the whole box.

So where else are investors going to go? The whole phrasing of the question is preposterous, but consider the following calculation, which should be familiar here. The S&P 500 currently trades at 19.3 times peak earnings (trailing GAAP basis), compared with a historical average for the price/peak earnings ratio of about 14, and if we only look at points where earnings were actually at fresh peaks, a historical average closer to 12. Suppose that earnings, currently right at the robust 6% trendline connecting S&P 500 earnings peaks from economic cycle to cycle across history, continue to grow along the peak of that historical channel over the next 5 years, and that the price/peak earnings ratio at that point touches, merely touches, a level of 16 - still well above historical norms. Given a current dividend yield of 1.84%, the resulting 5-year total return would be:

(1.06)(16/19.3)^(1/5) + .0184(19.3/16+1)/2 - 1 = 4.13%

... which is about what you can expect from money market funds.

This isn't a timing argument, because the quality of market action is at worst mixed, and investors may very well have some speculation left in them. Unfortunately, speculation at this point will simply cause further deterioration in the long-term returns that stocks are priced to deliver. It's not necessary for investors to actually shift from stocks to money market funds (in fact, it's impossible for them to do so, in aggregate). All that's required for a "bear market" is for investors to recognize how unsatisfactory the long-term returns are likely to be from prevailing valuations. Investors could discover this with simple algebra, and historically reliable algebra at that, but hope springs eternal.

A guy hears the doorbell ring one morning, opens the front door, and there's a snail on the doormat. So the guy picks up the snail, walks through his house, and tosses it out to the back yard. A few years later, the doorbell rings. The guy opens the door, and the snail just looks up and asks "now what was that all about?"

Treasury bills - despite unusually low yields during the past several years - have outperformed the S&P 500 index, including dividends, for what is now more than seven-and-a-half years (for an annualized total return of about 2.6% during this period). Stocks have gone nowhere, but they've gone nowhere in an interesting way. That's the problem with rich valuations - not that stocks decline predictably or persistently. Just that investors go through years of fluctuations, faithfully holding their stocks as investments, and in the end, find themselves just like that snail.

Market Climate

As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and mixed but tenuously favorable market action. That probably doesn't sound like a grand endorsement of market action, because it isn't, but internals displayed enough resilience on the market's decline early last week to warrant a very modest reduction in the hedge held by the Strategic Growth Fund. At present, the Fund remains just under 90% hedged, so it continues to have a substantially muted exposure to the impact of broad market fluctuations of just over 10% of portfolio value. It's possible that the Fund will move to a 20-30% exposure if any fresh market weakness here is accompanied by relatively firm internals (breadth, leadership, and resilience from various industry group and security types). Bond market action was not helpful in that respect last week, but we'll take our evidence as it arrives. For now, the Fund isn't likely to experience substantial impact from overall market fluctuations (though it is always impacted by any differences in performance between the specific stocks held by the Fund and the indices we use to hedge), but I'm also open to the possibility that investors will retain a speculative view toward stocks for some amount of time, and may modestly increase our market exposure if more evidence supports that possibility.

As always, that's no forecast either. The tenuous character of the Market Climate here is reflected by a proportionately light exposure to market fluctuations. On one hand, market breadth has been firm and a good number of individual stocks have been registering new highs. Against that, the major indices need not move much higher to once again appear overbought, and as I noted in a recent comment (Overvalued, Overbought, Overbullish), there has historically not been much merit in accepting market risk in similar conditions. A better possibility for the market would be a retest or break of recent lows in major indices like the S&P 500, without strong deterioration in market breadth, leadership, or industry group action. In other words, I would take a more favorable view of the market's speculative potential if it could establish a better base.

For now, the positive but very small exposure to market fluctuations carried by the Strategic Growth Fund should be viewed as reflecting a similarly positive but small expected return/risk profile for the stock market, on average, under prevailing conditions. As usual, valuations hold a major sway over long-term returns, but shorter-term returns are sensitive to the speculative preferences of investors, which is why the quality of market action is an important element of our investment approach.

In bonds, the Market Climate remained characterized by unfavorable valuations and unfavorable market action. On the basis of last week's bond market weakness, however, I did deploy some of the proceeds from our recent sales of precious metals shares into intermediate Treasury Inflation Protected Securities, slightly increasing the duration of the Strategic Total Return Fund to about 2.3 years. That's not a substantial shift, of course, but it does retain some of the inflation defense of the Fund without relying on precious metals very much.

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