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Thursday, November 06, 2008 4:59 PM

Sideline Cash Theory Revisited

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Let's explore the sideline cash theory in detail starting with an email from Minyan "PB" who writes:

"It appears that the Treasury isn’t going to guarantee money markets after December 18th and only funds that were in money markets on September 19th.

I think it's pretty clear that they’re trying to drive money back into the markets. It’s a dangerous and desperate move.
"PB" passed along a notice from Schwab on which his statements are based. I will equate the notice to the sideline cash theory shortly. Here is the notice.
The U.S. Treasury Temporary Guarantee Program (the "Guarantee Program") provides a guarantee to participating money market mutual fund shareholders based on the number of shares invested in the fund at the close of business on September 19, 2008. Any increase in shares in the account after the close of business on September 19, 2008, will not be guaranteed. If the number of these shares fluctuates over the period, investors will be covered for either the number of shares held as of the close of business on September 19, 2008, or the current amount, whichever is less.

If a shareholder closes his/her account with a fund or broker-dealer, any future investment in the fund will not be guaranteed. Additionally, if a shareholder transfers shares in a money market mutual fund that are covered by the Guarantee Program—for example, from one fund or broker-dealer (a "delivering firm") to another broker-dealer (the "receiving firm")—the shareholder may lose the benefit of the Guarantee Program upon closure of the shareholder’s account with the delivering firm, or upon transfer of the shares to the receiving firm. Investors with questions about a potential loss of coverage should contact the delivering firm before closing an account.

The Guarantee Program expires on December 18, 2008, unless extended by the U.S. Treasury.
Can The Fed Drive Stock Prices Higher?

Thanks "PB". I suspect you are correct about the Fed's intent. However, It will not work for two reasons. The first reason is that it may cause another run on Money Market Mutual Funds. The second reason is that the idea is just another version of the discredited sideline cash theory.

On the latter, I am stunned by the number of emails about sideline cash I have been receiving in response to Unrelenting Bullishness. Many people are telling me that money moves into stocks and that sideline cash is bullish. Here is one such email.

Jon writes: "If I sold $50 million of equity, and I now have $50 million in sideline cash, putting it back in the market (along with a million other people) would force the market up. Don't try to make it any more complicated Also, don't think of each transaction as a buyer and seller. If it was as simple as one buyer and one seller, the market would NEVER MOVE EVEN ONE POINT."

Sadly, this kind of thinking is running rampant. Jon, if you sold $50 million in equities you would indeed have $50 million in sideline cash (minus transaction fees).

However, Jim (who bought those shares from you), had $50 million in sideline cash before and does not have it now. All that transpired is the transfer of $50 million in sideline cash from Jon to Jim. Yes, it is as simple as that.

Money does not flow into the stock market except during IPO and secondary offerings. Otherwise the same amount of sideline cash (minus transaction fees) existed before and after someone buys stocks.

Sentiment, Not Sideline Cash, Is The Driving Force

Share prices do not move up because sideline cash comes in (because it can't happen in the first place). Share prices rise or fall because buyers or sellers are more aggressive in what they are willing to do. In other words shares are repriced and sentiment is the driving force.

Earnings announcements are a good example of repricing events. If a company misses earnings badly, stock prices typically fall. It does not take a single share to be sold to cause it to happen. On good news share prices are typically bid higher (buyers are more aggressive than sellers).

Repricing events happen every day, not only in the stock market but in all kinds of things including housing. For example, if a builder finishes a subdivision of 100 homes and sold 95 of them for $250,000 then offered the remaining units for $200,000, poof just like the value of every home in the subdivision would drop by $50,000 overnight. This would happen before even a single one of those remaining 5 homes sold.

Yes, if one throws $50 million at some illiquid issue, share prices will temporarily jump. However, days or perhaps even minutes later share prices will drift back to where they were before.

No Such Thing As Idle Sideline Cash

For those who want a second opinion, John Hussman has written about sideline cash on several occasions. Please consider There's No Such Thing as Idle Cash on the Sidelines.

The amount of "sideline cash" has been rising for years and will keep doing so unless money supply contracts. Yet the S&P 500 fell close to 40% anyway. Why? The reason is simple: Earnings were horrid the price people were willing to pay for those earnings dropped.

Stock prices rise and fall on sentiment changes every single day, not because money flows into or out of the market.

Mike "Mish" Shedlock
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