With the markets breaking out to new highs and entirely decoupling from economic and medical realities, it is not surprising to see a continued stream of analysis grappling for bits of data to support the bullish momentum.
One of the most prevalent myths that seemingly will not die is that of “cash on the sidelines.”
We have tried to debunk this inane thinking previously, as Clifford Asness wrote:
“There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”
As I observed early in the global financial crisis, you’re going to see a lot of chatter about “cash on the sidelines” in the months and years ahead. That’s because the Federal Reserve is creating a mountain of the stuff. The moment the Federal Reserve creates base money (currency and bank reserves) to purchase some asset, the base money it creates must be held by someone in the economy, at every moment in time, until it’s retired. A dollar of base money is just another type of “security.” A given holder of cash can try to get rid of it by buying other pieces of paper like stock shares or bond certificates, but the seller of the stocks or bonds immediately becomes the new holder of the cash.
So “cash on the sidelines” can certainly change ownership, but it can’t go “into” the stock market, or the bond market, or anywhere else, without coming right back out in someone else’s hands. Once a security is issued, that security has to be held by someone, at every moment in time, exactly in the form it was issued in, until that security is retired. That holds for base money as well.
Also remember that the moment the government runs a deficit, somebody has to run a “surplus” of income over and above consumption and net investment. That “surplus,” in equilibrium, is held in the form of whatever liabilities the government issued to do the spending. If the government finances the deficit by issuing Treasury bonds, someone is going end up holding more Treasury bonds. If the Fed buys the Treasury bonds and replaces them with base money, someone is going to end up holding more base money.
If investors are inclined to speculate, the pile of zero-interest hot potatoes created by the Fed can certainly encourage them to chase other assets, which is how the Fed has created an “everything bubble” in recent years. The problem is that as valuations rise, future return prospects fall, and we’ve now got the worst investment menu for passive investors in the history of the U.S. financial markets. Everything is priced for near-zero returns.
Saying that extreme stock market valuations are ‘justified’ by low interest rates is like saying that poking yourself in the eye is ‘justified’ by smashing your thumb with a hammer.
The chart below shows our estimates of prospective returns for a variety of asset classes based on methods which have a correlation of 0.89 or better with actual subsequent market returns. Each line shows a point of strong or dismal investment opportunity in recent decades. The current menu is among the most dismal investment profiles in history.
Meanwhile, the growing pile of “cash on the sidelines” is unlikely to stimulate consumption either. Why would holding “savings” in the form of zero-interest cash rather than zero-interest bonds materially change the financial planning of households or anyone else? The assumption seems to be that cash (ooh! cash!) must be consumed on goods, rather than paying down debt or remaining as bank balances.
In the end, someone is going to hold the base money, in the form of base money, until the base money is retired. The long-term financial planning of households and other sectors isn’t abandoned in favor of consumption the moment assets are held in a bank rather than a brokerage.
* * *
So now you know:
Cash on the sidelines? Not really.
Everyone “all in the boat?” Absolutely.
Historical outcomes from such situations? Not Great.