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The following is a guest contribution from Comstock Partners:

When making our bearish case for stocks we’re amazed at how often our audience brings up the old “cash on the sidelines” argument as a reason to doubt that the current rally can tank.  We have been in this business for a while and don’t remember a time when this fairy tale wasn’t trotted out as a reason to be super bullish.  In fact we don’t recall any point where observers ever said that the market was going down because there was not enough cash on the sidelines.

A relatively recent example was the summer of 2007 when a majority of commentators insisted that the availability of huge amounts of global liquidly would never allow the market to retreat.  The words were hardly out of their mouths (or word processors) before the ECB and the Fed were forced to pour hundreds of billions of dollars into their banking systems.  As we indicated at the time, liquidity is never there when you need it.

The fact is, as John Hussman has so eloquently pointed out, the purchase or sale of a stock is net neutral with regard to cash entering or leaving the market.  For every buyer there’s a seller, and for every seller there’s a buyer.  When “A” buys stock for $100,000 he/she has $100,000 less cash on hand, but “B”, the seller, receives the $100,000.  No net cash has entered or left the market.

The reason stocks go up or down is not a result of cash moving into or out of the market.  Stocks go up when prospective purchasers are more anxious to buy than sellers are to sell.  If there are more willing buyers than sellers at any given level the market has to go up to equalize demand and supply.  In fact, it sometimes doesn’t take any transaction at all to move the market.  If Intel reports surprisingly high earnings and Dell reports a disappointment the bid and asked price moves up or down before any transaction even takes place.

Furthermore, if even one anxious buyer of a relatively small number of shares drives up the price, the total capitalization of all the shares of that stock rises.  And if the purchases are a result of a real upside earnings surprise in a key bellwether stock, the entire market can rise without a dime of new cash entering the market.

Despite the obvious truth of this case, strategists and the media always bring up the old myth of “cash on the sidelines” to justify their bullish views of the market, particularly when their arguments for the economy and valuation are flawed.  If you hear anyone make this case just ignore them—it’s a fallacy.  If the market rally continues from here, it will happen as a result of buyers being more anxious to buy than sellers are to sell, not because sideline cash is entering the market.  If fundamental and technical conditions deteriorate as we expect, prospective purchasers will become less anxious to buy while sellers will be more willing to sell, and the market will decline by enough to equalize supply and demand.

Source: Comstock Partners

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