The Trouble With the ‘Sidelined’ Cash Theory

Every now and then, something weird happens to stock market sentiment: People get more bullish as returns improve, but for the wrong reasons. When it happens late in a bull market as people grasp at straws to justify sky-high forecasts, it can signal euphoria. We are nowhere close now. But we are seeing the more skeptical version, where people start eyeing false drivers while ignoring the actual positives that propel stocks. Today, we speak of the discussion surrounding Fed rate cuts and the increasingly widespread belief that as money market yields and other savings rates fall, money will pour from cash to stocks, propelling returns. Sounds nice, and we are bullish, but we think this is a myth.

The “cash on the sidelines” argument flares pretty regularly during bull markets. People line up stock, bond and money market fund flows—along with bank deposits—to show the potential for money to leap from cash (and sometimes bonds) to stocks. The presumption is usually that as this sidelined cash pours in, it will drive stocks higher and higher.

But reality and math disagree. Let us start with reality: Most of the cash in money market funds today doesn’t have the primary purpose of generating long-term growth. That is, it didn’t come from stocks to cash. It came from other, lower-yielding forms of cash.

Remember when Silicon Valley Bank imploded a year ago? That put a lot of focus on uninsured deposits (that is, account balances above the FDIC’s insured limit) and what would happen to them in a bank run. A lot of folks decided not to deal with this, especially with bank deposits still earning a pittance, and put their larger cash stockpiles into money markets. Some other amount of it is businesses’ cash reserves, which are necessary for liquidity and emergency buffers. Some of it is money people earmarked for near-term expenses. Some of it is individuals’ emergency funds and other cash holdings they deem necessary for financial security and their personal circumstances in general, figures that may have grown larger over the past two years simply due to folks rationally accounting for inflation increasing their cost of living. Therefore, if cash leaves money market funds, it will probably just go to other cash-like instruments. Interest rates may change, but the primary purpose for the money doesn’t.

Even if some of this money does make its way to stocks, this doesn’t amount to bull market rocket fuel. Yes, it could represent new buyers flooding the market. But this is where the math comes in: For every buyer, there is a seller. Therefore, every dollar going in is a dollar going out. Every purchase is a sale—the money cancels itself out.

Perhaps that is a bit abstract to think through, so, a scenario: Jim decides to buy 100 shares of our favorite fake firm, Widgets ‘Я’ Us, for a total of $1,000. He enters his trade with his online broker, and boom, 100 shares are his! But the market makers have matched him with Jane, who decided to sell 100 shares of Widgets ‘Я’ Us at that exact moment, for $1,000. Factor in a bit of back-end plumbing, and boom, Jim’s $1,000 has gone to Jane. New money didn’t enter the stock! Jim and Jane just swapped their $1,000 and 100 shares, respectively, via some intermediaries.

Here you might say, yah, but that is for existing shares. What about new listings and secondary offerings? Well, the mechanics are different, but the same principle applies. An IPO is a case of early investors selling their holdings to the public, sometimes with the company selling off a new piece of itself in the process. Still money going in and out at the same time. A secondary offering might look only like money coming in, but because the company’s overall worth and size hasn’t changed, it just dilutes existing shareholders, usually reducing the value of their holdings in the process. So it is still a transfer of money among stock owners and the company, not money going in and staying there. We know we are oversimplifying a lot of this to avoid boring you with technical jargon, but the fanciful scenario of new money pouring in with nothing coming out elsewhere just doesn’t exist.

Which is fine! Because in an auction marketplace like stocks, prices don’t depend on new money or a given number of buyers. They simply depend on someone’s willingness to pay more for a given thing. Stocks rise when buyers are willing to pay a higher price. They fall when buyers aren’t willing to do so and sellers accept a lower bid. It is all about relative eagerness to pay a premium or accept a haircut. It may not seem like an auction at retail investors’ point of use because you aren’t actually entering a bid while a fast-talking gentleman says “Do I have $30, $30, $30 here from the lady in white, gentleman says $40, do I have $45, $45, $60 says the grand dame in the velvet coat, going once, going twice, SOLD!” And the days of floor traders shouting at screens and screaming in phones to outbid one other verbally are mostly gone. But on the back end, in the vagaries of all the systems, market makers and computers at work, it is an auction. And in any auction, having more bidders may help—but it isn’t assured to.

So yes, the Fed may cut rates, and yes, money market funds may lose some allure. But it will probably be a sideshow to stocks, which will be busy discounting the likely reality of corporate earnings over the next 3 – 30 months and how that squares with current sentiment. And there should still be positive surprise potential on this front, in part because people will be distracted by fund flows and not looking at what is actually propelling markets higher. At some point they may even start getting annoyed that money isn’t pouring in and get frustrated, extending the wall of worry. But that is all distant and speculative. For now, what matters is that this bull market has fundamental support regardless of what the Fed does and where folks stash their cash.