Is The Cash On Sideline Argument Bogus?

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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?

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

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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