I have been in the investment world for over two decades and I can tell you that few topics are discussed more often in this business than the amount of cash that is "on the sidelines." Presumably, when there is more of it, potential for stock price appreciation is latent - when there is less of it, stock prices are vulnerable to fall.
Multiple generations have spun this yarn every which way imaginable. But, in the past few weeks, a veritable swarm of articles has burst onto the scene claiming that the core narrative underlying all such tales is merely an old myth. The "debunkers" are now passionately preaching to anyone who will listen that stock prices do not rise because of money "coming off of the sideline."
In this article we shall explore the truth of this matter.
Warning: Comprehending this may not be easy for some readers at first, but I can assure you that if you ever aspire to truly understand anything about how stock prices rise and fall in the stock market, you absolutely must master these concepts developed in this essay.
The Old Cash On the Sideline Myth
According to the traditional tale told by many generations of investors, analysts, traders and brokers, cash either moves "off of the sidelines" and "into" stocks, or "out of" stock and "onto" the sidelines. Typically, the following concepts and imagery are evoked by the narrative.
- Cash "comes off of the sidelines" and goes "into" stocks and/or the stock market.
- Cash "comes out of" stocks and/or the stock market, and then "accumulates" on the "sidelines" where it "sits" idle until it is once again "mobilized."
- Stock prices rise when "investors," as a class, take cash "off of the sidelines," and "put it into" the stock market in order to acquire stocks. This is because "putting money into stocks and/or the stock market" puts upward "pressure" on stock prices. Another way this is often expressed is that investor money is "placed into or thrown at the stock market" thereby causing stock prices to "inflate." After this sequence has occurred, "investors," as a whole presumably own less cash and more stocks.
- Stock prices fall when "investors," as a class, "pull their money out of" stocks and/or the stock market, and place it on the "sidelines" where it is accumulated in "piles" or "hoards." Prices fall presumably because the act of "taking money out of" stocks and/or the stock market "deflates" stock prices much like letting air out of a balloon will cause it to deflate. After this sequence has occurred, "investors," as a whole, presumably own more cash and fewer stocks.
I've got news for you, folks: This is not what happens. Under normal conditions, the "cash on the sidelines" narrative as an explanation why stock prices rise or fall is, in fact, nothing but a tell-tale. This mythical narrative has its origins in a defective cognitive model and associated false imagery.
Warning: If you ever want to truly understand anything at all about investment markets and the prices of investment assets, you need to completely erase this model and associated images from your mind.
I will briefly explain why the traditional "cash on the sidelines" narrative is a myth.
When a person with "money on the sidelines" uses it to purchase a stock in the stock market, that money does not go "into" stocks or "into" the stock market. This is because neither stocks nor the stock market are repositories that can "absorb" or "hold" cash.
When an investor "pulls money off of the sideline" in order to purchase stock, the money simply goes from one "sideline," to another "sideline" (or from one cash management account to another). In aggregate, therefore, at any given point in time, the EXACT same quantity of money will remain "on the sidelines," no matter what volume of stocks are bought or sold.
Similarly, when stocks are bought or sold, shares simply move from one brokerage account to another. In aggregate, no matter how many stocks are bought or sold, all brokerage accounts will contain the same EXACT amount of stocks after all the transactions are completed.
It is crucial to understand that during any given stock market session, after all transactions are completed, no matter how many stocks were exchanged, what value they were exchanged for, or by how much the stock rose or fell in price, there is not a single penny more or less of cash that is on the "sidelines," nor a single share more or less of stocks in people's brokerage accounts.
(Note: I do not consider in this essay the impact of net share issuance and/or changes in the money supply in the course of a single trading session as these factors typically do not play a major role in the stock price movements that occur in any given trading session. Amongst other reasons, the changes in these variables tend to be insignificant relative to the total quantity of shares outstanding and or aggregate supply of money.)
Let's use another analogy to describe the same process. When a person purchases a stock, a quantity of money exits the buyer's "pocket." What happens to that money? Well, it does not disappear. The EXACT same quantity of money enters into somebody else's pocket. In this case, the money is now in the seller's pocket. The same thing happens with the shares. Shares enter the buyer's pocket and the EXACT same quantity of shares exits the seller's pocket. Thus, the total quantity of cash and shares in all people's pockets remains EXACTLY the same.
Therefore, under normal conditions, the idea that "money coming off of the sidelines" and "placed into" stocks and/or the stock market causes prices to rise is a myth because, on aggregate, money never actually comes off of the sidelines nor does money "go into" stocks. For every buyer "taking money off of the sideline" and "putting it in stocks" there is a seller "taking money out of stocks" and "putting money on the sideline."
In reality, when shares are bought and sold on the stock market, money is simply going from "sideline" to "sideline" while stocks are being transferred from account to account. Since the total amount of money "on the sidelines" remains exactly the same, a posited abundance of money "on the sidelines" cannot be the cause of price increases. Similarly, the idea that "money moving out of stocks" and "onto the sidelines" causes prices to drop is a myth because the exact same amount of money that is moving "onto the sidelines" of the seller in one place is simultaneously coming "off of the sidelines" of the buyer somewhere else. Since the total amount of "cash on the sidelines" remains exactly the same, a posited dearth of cash "on the sidelines" cannot be the cause of price decreases. Therefore, speculative discussions about the amount of cash "on the sidelines" typically constitute idle and unproductive banter.
In sum, regardless of the volume of stocks that are bought and sold and/or the value at which they are transacted in any relatively small period of time, the amount of money "on the sidelines" and the amount of shares in brokerage accounts remains EXACTLY the same. Therefore, under normal conditions, stock prices do not rise or fall because cash "comes off of the sidelines" and "into stocks," or because cash comes "out of stocks" and "onto the sidelines."
Conditions Are Not Normal: The Anti-Myth of Money on The Sidelines
Under normal conditions, during any relatively short lapse of time, the amount of available cash (i.e. money on the sidelines) and the amount of available stock will be factors that will tend to be somewhat constant, while the price of stocks is a factor that will tend to be highly variable. In other words, at least over short periods of time, there is evidently a weak relationship between the quantity of money and quantity of stock on the one hand and stocks prices on the other.
Please note that by definition a rising money supply means that there is more "money on the sidelines " - i.e. there is more currency, deposits, etc. available for expenditure, including investment in stocks. Indeed, for all intents and purposes, "cash on the sideline" and the MZM money supply should be thought of as essentially the same thing.
Over time, however, the quantity of "money on the sidelines" and the quantity of stock can and do diverge. However, it is important to note that even over extended periods, a roughly constant relationship between these two variables will tend to be observed. Under normal conditions, the quantity of cash available for investment will preserve a discernible relationship to the aggregate supply of investable assets, including stocks. This is because under normal conditions, the money supply tends to rise as aggregate nominal income rises, and, in turn, the aggregate supply of investable assets will tend to follow the path of aggregate nominal income. Another way to express this is that, over time and under normal conditions, the path of real income plus credit will tend to drive the growth of investable assets. (Note that growth in the supply of credit will be reflected in the supply of money. Credit is money, for all intents and purposes).
But conditions are not always normal. And in this vein, we may ask: What happens when and if the quantity of money rises much faster than aggregate income, credit and/or the quantity of assets?
This is where the quantity of "money on the sidelines" may become a relevant consideration for the future evolution of stock prices.
Under such circumstances, many people will hasten to speculate that some of this increased aggregate supply of "money on the sidelines" will likely find its way "into" stocks, thereby causing their prices to rise. Unfortunately, in many ways, this is the wrong way to look at the issue. First, as I stated before, money does not go "into" stocks. Second, the presence of "new" money does not imply that the demand for stocks at any given price will rise. For example, conditions leading to a precipitous rise in the money supply (e.g. deep recession or high inflation) could provoke a decline in stock prices. This is, in fact, exactly what happened between 2007 and 2011. Over that period of time, stock prices declined very significantly from their all-time highs in 2007 despite an unprecedented explosion of the available supply of money, or the amount of "cash on the sidelines." And again, I will remind readers that it is not because cash "remained on the sidelines" that stocks fell in value. If every single dollar of those available funds had been used to purchase stocks, the exact same quantity of cash would still be "on the sidelines." Furthermore, it was not because cash "exited," "fled," or was "pulled out of" stocks and "piled onto the sidelines" that stock prices fell. If large quantities of cash were moved "onto the sidelines" after sales, that exact same quantity of cash must necessarily have moved "off of the sidelines" somewhere else in order to purchase the very stocks that were sold. Therefore, the aggregate supply of cash "on the sidelines" remains exactly the same, regardless of the quantity purchased or sales executed.
The price of any good - including stocks - rises or falls as a function of the perceived value assigned by marginal buyers and sellers to a given quantity of cash relative to a given quantity of a good. Many, many factors can affect these ultimately subjective perceptions of relative value.
Let us assume for one moment that an increased quantity of "cash on the sidelines" combined with a decrease in liquidity preference are two factors that contributes to shifting preferences for cash relative to other goods. Then we have a situation in which the holders of cash might bid up the price of certain goods that displace cash on their scale of preferences. I want to reiterate the fact that the value of stocks and other investment assets can fall when the aggregate supply of money rises and vice-versa. There is no necessary relationship between the money supply and the prices of investment goods and/or consumer goods. But all variables remaining equal, a large increase in the amount of available cash (investable funds) combined with a decline in liquidity preferences will tend to exert upward pressure on the value of consumer good and/or investment assets, and especially if the supply of these goods is relatively inelastic. Which consumer goods and/or investment assets might rise more or less in price in such a situation? Stocks are one of many types of goods along with jelly donuts, gold bullion (GLD), bicycles, apartment buildings, gasoline at your local Exxon (XOM) station, and Apple (AAPL) iPhones that might at least be considered as potential candidates for price increases. The prices of which goods will ultimately rise and by how much (if at all) depends on a great many factors (beyond the mere quantity of money) that are beyond the scope of this article to discuss.
Under normal conditions, the traditional "cash on the sidelines" narrative explaining stock price appreciation is a myth. But conditions are currently not normal. First, it is a fact that there is more "cash on the sidelines" around the world than ever before, and that the Fed and other central banks around the world have announced that more of it is coming. Second, it is also a fact that liquidity preference is currently unusually high due to a succession of recent crises and that state of affairs could be at or near an inflection point as risk aversion eases and reverts toward historical norms. Under such circumstances, unusually high levels of cash "on the sidelines" (i.e. money supply) may be relevant, and the new converts debunking the old myth of "sideline cash" may be preaching exactly the wrong message at exactly the wrong time.
In a scenario in which the amount of "cash on the sidelines" has risen greatly and liquidity preference falls, the relative preference for cash compared to other assets at the margin may change. What is relevant to note about such a scenario is not that investors on aggregate will "rotate" out of cash and into stocks and/or bonds. As I have pointed out previously, no such rotation is possible, as at any given point in time, the aggregate quantity of cash, stocks and bonds held in all portfolios must remain equal no matter how many stocks and or bonds are bought or sold. The relevant fact to be noted in this scenario is that shifts in relative marginal preferences lead investors to bid up the newly favored assets and/or bid down the newly disfavored assets.
Note that an incidental byproduct of such relative price movements amongst assets is that aggregate portfolio composition (measured by the relative market value of all assets in all portfolios) changes. Again, this change is not due to aggregate "rotation" out of one asset class and into another (which is impossible), but is rather a function of relative price changes.
It is crucial to understand that significant price changes require no change in the availability of cash at all. In fact, major price changes generally occur despite little or no change in the aggregate availability of cash. Furthermore, major price changes do not even require a significant volume of transactions to be realized. Stock prices can "gap up" or "gap down" by large magnitudes on virtually no volume, while they can "churn" and remain unchanged on heavy volume.
For reasons that should now be clear, it would be foolish to suppose that the mere fact that the money supply (cash on the sidelines) around the world is rising, will cause the price of stock indices and index ETFs such as SPY, DIA and QQQ to rise significantly. There are many other factors that must be considered, some of which are far more important than the money supply or "sideline cash" issue. However, under the current set of circumstances, it would also be foolish to declare categorically that it is "myth" that "sideline cash" may play a role in the evolution of stock prices.
The rise or fall of "sideline cash" - properly understood as the money supply - may be one factor that, in combination with others, can co-determine stock price movements under certain circumstances.