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July 10, 2006

There's No Such Thing as Idle Cash on the Sidelines

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

“No, but you're… you… you're thinking of this place all wrong. As if I had the money back in a safe. The ... the money's not here...”

- Jimmy Stewart in “It's a Wonderful Life”

There was a farmer who harvested his field of corn. He sold all but 100 bushels. A few weeks later, he lent the 100 bushels of corn he had saved to a cereal maker, who gave the farmer an IOU that said “100 bushels of corn,” made a big box of corn flakes, and sold it. The next year, a famine struck. People looked hopefully at the farmer, seeing the note that said he had 100 bushels of corn. All that corn, just sitting on the sidelines! If only the farmer would put that corn on the sidelines to work, they thought, then everything would be fine...

One of the hurdles in thinking properly about the financial markets is to understand the idea of “equilibrium” – that all securities issued must be held; that savings must equal investment; that every share bought by someone must be sold by someone else.

… and that there's no such thing as “idle cash on the sidelines.”

That last one isn't easy to grasp. After all, you can look at your own brokerage account and say – “look right there at that cash balance. There it is, on the sidelines, just waiting for me to put it into the market.”

But if you look more closely, what you really have is an IOU. It might be a very liquid one, like a money market fund that holds T-bills and commercial paper, but it's still an IOU. See, your “cash on the sidelines” isn't sitting there idle, waiting to be put to work. The fact is that it has already been put to work.

And when you go to put your “cash on the sidelines” to work, what really happens is that your money market securities (T-bills, commercial paper, etc) now have to be sold to someone else. And at that moment, the cash on the sidelines that you had suddenly becomes somebody else's cash on the sidelines. And that same amount of cash on the sidelines will continue to exist until the borrowers pay it off.

Likewise, investors should not believe that the “cash on the balance sheets” of corporations might suddenly be used, in aggregate, for new investments and capital spending. That cash on their balance sheets has already been deployed as loans to the Federal government and to other companies.

Now, yes, if the government runs a surplus and retires its debt, in aggregate, or the other companies that borrowed the money generate new earnings and then pay off their debt, in aggregate, then those new savings that retire the T-bills and commercial paper then make it possible for the recipients to finance new investment, in aggregate. So as usual, savings equals investment, and new savings can finance new investment. But what investors often point to and call “cash on the sidelines” is really saving that has already been deployed and used either to offset the dissavings of government or to finance investments made by other companies. Once those savings have been spent, you can't, in aggregate, use the IOUs (in the form of money market securities) to do it again.

In other words, the amount of cash that investors hold “on the sidelines” is determined by the amount of borrowing that has occurred in the form of money market securities like T-bills and commercial paper. It's a lapse of proper thinking to believe that investors, as a group, can move their “cash on the sidelines” into the stock market, or that companies, taken together, can turn their “cash on the sidelines” into new investment and capital spending.

I've said this before, but it's important. If Ricky sells his money market shares and buys stocks, then his money market fund has to sell commercial paper to Nicky, whose currency goes to Ricky, who uses it to pay for the stock bought from Mickey. In the end, the currency that Nicky held is now held by Mickey, the commercial paper held by Ricky is now held by Nicky, and the stock held by Mickey is now held by Ricky, and there is exactly as much stock, commercial paper, and currency outstanding as there was before. All that happened is that the owner of each security has changed.

The price of any given security may or may not have changed as well. For example, if Ricky is very eager to buy stocks and Nicky and Mickey are happy with their existing positions, then Ricky probably has to sell his commercial paper to Nicky at a discount, and has to buy the stock from Mickey at a premium. What happens here is that Ricky has to sell more units of commercial paper for a given amount of cash, and more units of cash are required to buy a given amount of stock. So in this case, commercial paper prices fall (interest rates rise) and stock prices rise.

In contrast, it might be that Mickey is eager to sell stock and Nicky is eager to buy commercial paper. This is good for Ricky. In that case, Ricky might sell his commercial paper to Nicky at a higher price, while buying Mickey's stock at a discount. In that case, commercial paper prices rise (interest rates fall) and stock prices fall.

As a final note, we might know that, say, Mickey, tends to be a poor investor, and generally gets out of stocks after significant declines and gets into stocks only after significant advances. So, we might very well want to monitor the amount of cash that Mickey holds. But in this case, the amount of cash held by Mickey isn't a useful indicator because it measures potential “inflows into the stock market” – rather, it's useful because it's a sentiment indicator. It's still true that in aggregate, the cash is going to stay on the sidelines.

In any case, stock prices don't change because money goes “into” or “out of” the market. Prices change because buyers are more eager than sellers, or vice versa. If a dentist from Poughkeepsie is eager to buy a single share of General Electric (which has about 10 billion shares outstanding), and pays $33.30 instead of $33.20 for that single share, that one trade will increase the stock market's capitalization by a billion dollars. But at the end of the day, all securities that were originally in existence are still in existence, and there is just as much “cash on the sidelines” as there was before.

The upshot here is that investors should never look at "cash on the sidelines" as an indicator of potential buying pressure. It just isn't so. The cash is going to stay on the sidelines until the underlying debt securities are retired.

There is an important reason for these considerations here. As I've noted in recent months, it's likely that China and Japan will at least stabilize in their willingness to absorb the flood of government liabilities that they've been snapping up in recent years. That means that more of these liabilities will be forced into the hands of U.S. investors. As that happens, we're likely to observe an accumulation of “cash on the sidelines” that might look like a hopeful sign for stocks. It will be helpful to remember that the accumulating pile of “sideline cash” actually represents money already spent.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. The “clearing rally” from the oversold conditions of recent weeks became a fully extended short-term overbought condition last Monday. At present, the stock market features an unfavorable Market Climate, a still somewhat overbought short-term condition, and an absence of any important seasonal support. While it's possible that investors will take hope from the weak employment report and upcoming earnings season, there's a wise rule that Richard Russell has noted over the years: “in a bear market, anything that can go wrong will go wrong.”

That idea is relevant here, not because our own approach is defined in terms of bull/bear distinctions (it isn't), but rather, because I've noticed over the years that the market's reaction to “news” of any sort tends to key off the prevailing Market Climate more often than not. So given a piece of ostensibly good news – a tepid employment report that somewhat increases the likelihood of a “Fed pause” (not that I think it matters) – the market sold off Friday “despite” that report, or possibly because of concern about earnings, but in any case, investors found that seemingly “good” news produced a bad market outcome.

My expectation for that sort of negative bias will shift, of course, as soon as we observe a favorable shift in the observed Market Climate. For now, however, there's not much evidence in market action that investors have a broad, robust preference to accept risk, nor is there much evidence from valuations that an exposure to market fluctuations has much long-term investment merit.

In bonds, the Market Climate remains characterized by relatively neutral valuations and relatively neutral market action. There will certainly be conditions (and have been historically) where aggressive exposure to interest rate fluctuations and duration risk is worth taking. This is not one of them, but it isn't terribly negative either. Presently, credit spreads remain well behaved, so there's nothing to send investors clamoring for the safety of government liabilities. Given the possibility that foreign investors will absorb less of the growth in those liabilities, I have continued concerns about persistent, structural inflation.

Meanwhile, yield levels aren't particularly rich in relation to inflation, prospective economic growth, and other factors. So very little presently compels us to hold a bond market position of much duration. Accordingly, the duration of the Strategic Total Return Fund remains about 2 years. I did clip off a few percent of our precious metals stockholdings on last week's price strength, now to about 12% of net assets. That's still a positive, constructive position, so the small reduction was driven more by risk management and short-term strength than any significant change in the Market Climate for precious metals shares.

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New from Bill Hester: Relative Value and Relative Returns

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