Have you ever seen the graphs showing “Look at all the money sitting on the sidelines!  This market has to go up!”  Those analyses are bogus.  Why?

Is The Cash On Sideline Argument Bogus?

Several reasons, but the leading one is that much cash has to be held as part of portfolio margining, securities lending, or derivative agreements.  What would be valuable, maybe is a graph of cash that is free to be spent on new securities.

The word “new” is important.  With most trading, liquidity does not disappear.  Instead, liquidity moves from the account of the buyer to that of the seller.  When is that not so?

With initial public offerings, where the proceeds are not solely going to selling shareholders, liquidity disappears into the coffers of the new company, that it can do business.   That’s not a bad thing, aside from periods in the ’60s and late ’90s where there was a craze that led people to invest in bogus businesses that sounded cool.

When there is too much liquidity available to invest, Wall Street produces new companies to absorb the liquidity, many of which will be of dubious value, because there is money to be made.  Trot out the speculative stocks and bonds, especially near the end of the boom phase of the credit cycle.

Liquidity disappears into new corporations, and reappears when corporations are bought for cash.  Aside from a few other similar events, secondary trading has no effect on liquidity.  So when you hear that there is a lot of liquidity on the sidelines, review the above arguments and say, “There is almost always a lot of liquidity on the sidelines, but is it buying up new stock issues?”

Therefore, look at the quality of new IPOs.  Quality is a thermometer for whether the market is cold to overheating.  The same applies to corporate M&A to a lesser extent when they purchase poor assets for cash.  On the other hand, if corporate M&A is finding inexpensive assets that they buy for cash, the market as a whole may be cheap.

Secondary trading does not inform us much about market valuations.  Look to the primary markets, where cash creates new assets, and where old assets get sold for cash.  Valuations are on display there, and should inform our investing.

By David Merkel, CFA of Aleph Blog