Submitted by Pater Tenebrarum of Acting Man blog,
It’s Not a Bullish Argument – It Isn’t an Argument at All
JP Morgan stock market strategist Tom Lee is frequently interviewed by the mainstream financial media and well known as a staunch bull over the past several years. Obviously he has been right so far, but that tells us nothing about the future (by contrast, we have been skeptical for at least three years, although it should be noted that our skepticism relates to the very real risks the market poses and is not a ‘prediction’). It also tells us little about his qualities as a forecaster, since the market advances almost 67% of the time (a side-effect of continuous monetary inflation, which is the by far biggest component of the stock market’s nominal advance over the past century). There are many perma-bulls out there who are hailed as prescient ‘bottom callers’ in the media, but if you’re bullish all the time, you simply can’t miss eventual bottoms. Moreover, you will be right 67% of the time, which is a quite comfortable win rate for a forecaster. Many of the former ‘Ruykeyser elves’ provide good examples for this principle. So we will have to wait and see how Mr. Lee handles a complete cycle.
One might be inclined to conclude that given that it is the correct stance for two thirds of the time, that it is actually a good strategy to be bullish all the time. However, in secular bear market periods it is only a good strategy for the forecasters themselves, but certainly not for anyone else. Anyone who bought the market in 2000 in the form of a broad index like the SPX and simply held on is still down in real terms fourteen years later, in spite of the nominal new highs that have been achieved in the meantime. It would have been far better and less nerve-wracking to just hold treasury bonds, and even better to hold gold (of course holding gold was a bad idea between 1980 and 1999, but this only shows that every investment class has its season).
Moreover, the buy-and-hold strategy would have included two truly nerve-wracking drawdowns of 50% and 58% respectively, which were among the worst bear markets in all of history. It is easy to say for the guys on TV that people should just hold through such massacres – it’s not their money after all. However, one needs a 100% gain to make up for a 50% loss, so this is no trivial matter, especially not for people close to retirement. Getting caught in such a drawdown of course makes no sense if one is young either – it is just as nerve-wracking and hard to recover from, but obviously one has more time and therefore more opportunity to make up for losses.
It is an incontrovertible fact that the most recent bull market has been driven by massive monetary inflation, just as its two predecessors have been (the true money supply has increased by roughly 90% since 2008, and that is not counting money that has ‘leaked out’ from the US). It is therefore definitely appropriate to exercise the utmost caution, since we know how asset bubbles driven by monetary pumping must inevitably end. Cash, or rather money, is the topic we want to briefly discuss in this context.
In Tom Lee’s most recent interview, he asserts the following:
“This could be only the middle innings of what could be one of the longest bull markets in history,” Lee said in a “Squawk Box” interview. “There is a lot of firepower to fuel this rally. There is a lot of cash on the sidelines, consumers have delevered.”
We take great exception to the first half of the last sentence, as it contributes to the dumbing down of CNBC’s viewership. It is deplorable when such long discredited myths are propagated by so-called experts.
Let us think about this statement for a moment. What is ‘cash on the sidelines’ even supposed to mean? We submit that it is a meaningless concept. All stocks are owned by someone at all times, and all cash is held by someone at all times. When people trade stocks, all that happens is that the ownership of stocks and cash changes hands. There is as much ‘cash on the sidelines’ after a trade concludes than there was before. There are no owner-less orphan stocks flying about in the Wall Street Aether, waiting to suck up cash.
In other words, the ‘cash on the sidelines’ argument is a really bad argument, or rather, it’s not an argument at all. There is one tiny kernel of truth to it, which we discuss below.
The Proper Approach
There are nonetheless ways in which the topic of ‘cash’ (or rather money, since most money is held as deposit money these days) provides useful information for the purpose of market analysis. As indicated above, the pile of money extant in the economy is after all indeed growing, and it has done so at a breakneck pace over the past few years. The central banks and the commercial banking system are actually the only sources of additional ‘sidelines cash’ if you will. However, this does actually not mean that any increase in the money supply will guarantee rising asset prices. Rather, bubbles require very high money supply growth rates, and often they require accelerating growth rates (there are leads and lags involved, so this is not always immediately obvious).
What asset price bubbles cannot stomach is a slowdown of the money supply growth rate below a certain threshold (this threshold is obviously not a fixed quantity). Regular readers know that we usually refer to the money supply aggregate TMS-2 in these pages (the broad true ‘Austrian’ money supply) as the most reliable aggregate to follow. Casey Research has recently posted a chart that shows an overlay of the growth rate of TMS-2 with major financial market events. This shows empirically what we already know from sound theory: namely that a decline in the growth rate of the money supply is the decisive factor bringing on financial crises and bear markets.
Here is the chart, which also indicates where approximately things stand at the moment:
The annualized rate of change of money TMS-2 and major crises. As can be seen, there considerable lags involved. A good rule of thumb for the lag time is four to five months per expeirence (i.e., how long it takes for large changes in the money supply growth rate to affect economic activity and asset prices) – click to enlarge.
Are there any other indicators one might want to follow in the context of the ‘how much money is there to drive asset prices’ question? The answer is that yes, there are several. However, these indicators are merely telling us something about the sentiment and positioning of various groups of investors. Changes in these indicators have of course no bearing whatsoever on the amount of money extant in the economy. The money supply is wherever it is at any given moment (it currently grows every day, albeit at a slowing rate), while these indicators are all over the place. However, Tom Lee has very likely referred to one or more of these indicators. We infer this because he certainly didn’t mention the money supply and whenever analysts broach the ‘cash on the sidelines’ myth, these are the data they are as a rule talking about. In one sense there is a kernel of truth to the idea: individuals can certainly alter the allocation of their income between consumption, cash holdings and investments. If they as a group want to hold less cash and more investment assets, money will decline in purchasing power relative to such assets, ceteris paribus.
The first data point we want to look at are retail money market funds. These merely tell us how much of their investable savings members of the public have stashed in ‘safe’ money market accounts. In other words, this number indirectly tells us something about the public’s willingness to invest in assets considered either risky or safe. Below we show two charts relating to this money market funds: the percentage of Rydex assets held in money market funds (a sentiment measure of active small stock market traders), as well as retail money funds in toto and where they currently stand historically. Note that the second chart shows a dollar figure, so given the decline in money’s purchasing power, it is in even worse shape than it looks on a superficial level.
Rydex money market fund assets as a percentage of all Rydex assets have hit their lowest level since March 2000 at the end of 2013. Not a propitious indication with respect to the ‘cash on the sidelines’ myth. Rydex traders sure seem to be as ‘all in’ as they ever get – click to enlarge.
All retail money funds (NSA) – over the past 18 months. They have been mired near the lowest levels in 16 years – click to enlarge.
There is certainly no indication whatsoever that the public currently has a strong preference for safe money market investments. The public has in other words likely already piled into ‘risk’, including stocks.
Another indicator that is worth examining is the amount of cash held by mutual funds relative to their assets. As a ‘signal’ it has not been very useful for quite some time now, but it nevertheless tells us something about the sentiment of fund managers. As a long term chart reveals, the previous secular bull market was undergirded by a great deal of skepticism on the part of this group, and it ended when its skepticism vanished into thin air in late 1999/early 2000. What do these luminaries currently think? They are at their most bullish in all of history, and as fully invested as they can possibly be.
Mutual fund cash – fund managers were deeply pessimistic in the first decade of the last secular bull market, and when their pessimism gradually unwound in the 1990s, the bull market went into overdrive and became the biggest bubble in terms of valuations ever seen. Right now this group harbors exactly zero skepticism and is invested up to its eyebrows – click to enlarge.
Finally, one can also examine margin debt, which shows us the extent to which investors are prepared to speculate with borrowed money. It is well known that margin debt currently stands at a record high, but below we show a chart from Doug Short that gives us a close-up of the investor net credit situation at the NYSE, which is at its most deeply negative level in history.
Apart from the fact that the entire ‘cash on the sidelines’ argument is extremely flawed on a fundamental level, it is in our opinion quite dubious for a market expert to invoke this myth in view of such data points. This is not the picture of ‘fuel for a bull market in its middle innings’, it is rather a warning sign with an exclamation point.
NYSE credit balances are deeply negative and investor ‘net worth’ is thus at its lowest level ever. Fuel for a bull market certainly existed in late 2002/early 2003 and again in late 2008/early 2009, but by now margin debt has expanded to truly vertiginous heights. Not even the tech mania of 2000 can any longer hold a candle to this – click to enlarge.
The Only Source of Additional ‘Sidelines Cash’
Apart from individuals altering the allocation of their surplus funds – which is something a few of the above charts are giving us indirect information about – money supply growth is the only way in which additional cash can become available for investment in the stock market. Money is either created via inflationary lending on the part of the fractionally reserved banks, or by the Fed directly, in permanent open market operations (or ‘temporary’ ones that are continually rolled over). ‘QE’ is also a kind of permanent open market operation, and has been the major source of money supply inflation since the 2008 crisis. Note here that ‘QE’ creates both excess bank reserves and new deposit money, as the primary dealers the Fed buys assets from are legally non-banks, even if most of them are subsidiaries of licensed banking institutions (if the Fed buys securities directly from a bank, only excess reserves are created).
Money supply growth is clearly the main driver of stock prices. It would be a refreshing change if prominent market analysts had the intellectual honesty to occasionally point this fact out.
Here is a picture of all the actual ‘sidelines cash’ created over time – with the period since 2008 highlighted:
Money TMS-2. Here it is, the ‘sidelines’ cash. All of this newly created money of course continues to exist and is held by someone. In that sense, it is therefore always ‘on the ‘sidelines’ – click to enlarge.
The ‘cash on the sidelines’ myth has more lives than a cat. No matter how often the logical fallacy underlying it is pointed out, Wall Street continues to propagate it. Nevertheless, money and credit are of course extremely important factors in the analysis of asset markets. The above provides what are hopefully a few useful pointers as to which data one should keep an eye on in this context.