I turned on some financial TV last week only to find a well known pundit talking about all that “cash on the sidelines”. It’s been a long time since I reiterated this myth so I went back in the archives and cleaned up my old debunking of this myth. The following is the result. Hopefully this will move us one step closer to slaying this mythical beast!
If you turn on financial TV for a bit you’ll likely hear the term “cash on the sidelines”. This term is generally used during a bullish market commentary in which the pundit is pointing out that there is all this money that needs to “get into” the market. This leads one to believe that there is some sort of fuel that will necessarily drive the market higher. But it’s not true at all.
Cash, in a brokerage account or any account, is always an asset and a liability. Physical cash, the type you have in your wallet, is a liability of the US government and an asset for the holder. Cash, on a corporate balance sheet or a brokerage account isn’t physical cash. It is usually just short-term liabilities like Treasury Bills or Money Market funds made up of short duration debt instruments. This “cash” account is made up of instruments that are always someone’s asset and liability just like physical cash. T-bills, for instance, are a liability of the US government and an asset of the holder. So, when “cash” balances rise so too do both the asset side of the balance sheet and the liability side of the balance sheet. We can’t talk about “cash” assets increasing in the economy without also acknowledging that this necessarily means the liabilities have also increased. An increase in cash (usually as a result of borrowing) can be both good and bad depending on its use.
When someone says there is “cash on the sidelines” they are generally misunderstanding both the accounting described above and the transactional dynamics that occur in markets. For instance, when you decide to buy stocks you are also deciding to sell your cash. In a brokerage account this actually means that your short duration instrument (called cash) is being sold and exchanged for the stock. So, you are buying stock, but someone else is buying your cash. This results in a clean swap of financial assets. There isn’t more or less cash on the sidelines after this transaction. There is the exact same amount of cash on the sidelines before and after this transaction.
Of course, the price that is arrived at during the course of this transaction is a function of the eagerness of the buyer and seller to transact. If you have $100 in cash and are very eager to buy $90 worth of stock, but I am holding $95 worth of stock and am not eager to sell then you might be more inclined to purchase my stock for $95 than I will be eager to sell it at $90. Although the quantity of cash relative to stocks is a factor in driving demand for stocks it is not the dominant factor that drives value. That, after all, is a function of profits.*
Importantly, cash levels can rise as a function of balance sheet expansion. If I take out a loan my cash/deposit balances will increase. So too will my liabilities (the loan). And while this might give me more purchasing power to buy stocks it does not necessarily mean that prices must move higher because, as I described above, the sellers might actually be more eager to sell than the buyer’s eagerness to buy. So, next time you hear the “cash on the sidelines” myth remember that it’s important to maintain the right context. If you don’t you might be fooled into thinking that this is a necessarily bullish or bearish argument when it’s not.
* A good way to think about this is to consider what happens when a corporation implements a stock buyback. Let’s say company A has 100 shares outstanding and earns $100 in year 1. In year 2 they decide to buyback 10 of those shares, but they earn the same $100. This should boost the value of the stock because the current outstanding shares are worth more per share. There is, in essence, more money per share in this case if we assume that the quantity of cash in the system has not changed (because there are fewer shares for that cash to bid on). But consider this alternative. Let’s say the company buys back 10 shares and earnings fall to $50 because the company employees decide to go on vacation for 6 months. In this case the number of shares has fallen relative to year 1, but the value of those shares has actually declined even though the quantity of money relative to outstanding shares has increased. This means the price of the stock will very likely decline even though the quantity of money relative to outstanding stock has increased.