Question about the role of money on the sidelines in the stockmarket

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DavidLachman's picture
DavidLachman
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Question about the role of money on the sidelines in the stockmarket

The recent podcast attempted to dispelled the notion that money on the
sidelines was not a stock market driver.  That somehow there was always
the same amount of money in the stock market before and after a sale. 
While technically true, I think this misses an important component in
stock market valuation dynamics. 

To keep things simple imagine a
company ABC that is selling a $10 a share and in a society where there
is very little extra savings or 401k money to put in the market hanging
around—most people are poor or fully invested—in this case other things being
equal there is very little pressure for the stock price to go up, I can
sell some DEF stock to buy some ABC stock or one of the few people that
isn't fully invested can buy ABC or DEF without selling something
else.  Now imagine a situation where there is a lot of money on the
sidelines, everyone has sold off and their brokerage accounts are full
of dollars and they are waiting to get back in, they have money on the
sideline.  All the news outlets and financial advisors finally say the
bottom is in and everybody believes it.  Well, what happens, when there
are a lot of buyers for a fixed number of shares, prices rise.  The
stock goes from $10 to $12 to $15 to $20 over the course of a couple
weeks as all the sideline money tries to buy low as it comes back into
the market.  So while it was true that each transaction did not change
the amount of value in the market at the moment of exchange, the money
on the sideline did cause a rise in prices that inflated the price of
the stock as it all poured back in and sellers could ask more and
buyers tried to outbid other buyers in the cash on sidelines group as
they vied for the fixed number of shares in ABC.  It seems like this is
a simple supply demand relationship.  Am I missing something here?  It reminds me of the dynamic of the last 20 years as more and more boomers had money to put into stocks (ie money on the sidelines) and prices rose to the point that p/e ratios did not make sense.

Thanks for helping out (Erik, anyone else)!

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cat233
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Re: Question about the role of money on the sidelines in ...

David,

I could make this really long... or just add a few things into the mix that you haven't mentioned in your scenario.  Initial Public Offerings (IPOs)  and stock splits.

 

Example of a split calandar from three years ago, for one month.

Splits Calendar Archive  
Archive Date: Wednesday, January 18, 2006
 
 
 
January
Company Symbol Ratio Payable Ex-Date*    
J&J Snack Foods JJSF 2-1 Jan 05 Jan 06    
PAR Technology PTC 3-2 Jan 06 Jan 09    
Psychiatric Solutions PSYS 2-1 Jan 09 Jan 10    
Panhandle Royalty PHX 2-1 Jan 09 Jan 10    
Cerner CERN 2-1 Jan 09 Jan 10    
Hi-Tech Pharma HITK 3-2 Jan 11 Jan 12    
New River Pharma NRPH 2-1 Jan 12 Jan 13    
Papa John's PZZA 2-1 Jan 13 Jan 16    
Coldwater Creek CWTR 3-2 Jan 13 Jan 17    
LKQ Corp LKQX 2-1 Jan 13 Jan 16    
TALX TALX 3-2 Jan 17 Jan 18    
First National Bancshares FNSC 3-2 Jan 17 Jan 18    
Brooke Capital BCP 3-2 Jan 20 Jan 23    
Nitches NICH 3-1 Jan 20 Jan 23    
CVB Financial CVBF 5-4 Jan 26 Jan 27    
Mercantile Bank MRBK 3-2 Jan 27 Jan 30    
Financial Federal FIF 3-2 Jan 31 Feb 01    

 

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DavidLachman
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Re: Question about the role of money on the sidelines in ...

Hi Cat233,

I'm not sure what your post meant regarding my question.  Maybe I wasn't clear enough in my post.  I was trying to get at the topic of money on the sidelines and what that could do to stock prices.  Chris's podcast brought up this topic and he seemed to suggest that the was no effect of money on the sidelines because cash in equaled cash out for any particular sale.  It seemed to me that if a lot of money on the sidelines started to come back in it would have the effect of raising stock prices.  Simple supply demand relationship.  I didn't understand how Chris's comments dispelled this effect. Maybe I misunderstood what Chris was saying in his podcast.

As for your additions I understand how ipo's would increase the capitalization of the stock market.  Stock splits should have no effect as a $100 stock would be the same value as 2 $50 shares if the stock was split in two.

Thanks,

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cat233
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Re: Question about the role of money on the sidelines in ...

David,

I will have to go back and listen to exactly what Chris said in his podcast and get back with you (probably tomorrow).  Why I  mentioned splits is you were talking about supply and demand, and if a stock is in short supply it will keep splitting and splitting relatively quickly, adding to the supply.   Yes, fundamentally nothing changed about the company and the price was cut by whatever the split was, but there is more supply of stock to sell.

Cat

 

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Re: Question about the role of money on the sidelines in ...

I mentioned the name John Hussman in the podcast and Mr Hussman has completely dominated my view on this matter with his clear articulation of the issue of "money on the sidelines":

I am increasingly losing confidence that Wall Street operates on a well-defined base of knowledge. Instead, I am struck by the number of platitudes and false constructs that seem to dominate the investment management industry.

First, we should be very clear that there is no such thing as money going into or out of a secondary market. When stocks are issued in an IPO, or bonds are floated to investors, companies receive funds from investors and, in return, give investors pieces of paper called stocks and bonds, as evidence of the investors' claim on some future stream of cash. This is a “primary market” transaction.

Once those pieces of paper are issued, they are traded between investors in the “secondary market.” When we talk about the stock market, we're talking almost exclusively about the secondary market, because new issues make up a very small part of total activity.

Dear Wall Street analysts and financial reporters – when investors purchase a stock in the secondary market, the dollars that buyers bring “into” the market are immediately taken “out of” the market in the hands of the sellers. It is an exchange. This is why the place it happens is called a “stock exchange.” The stock market is not an air balloon into which money goes in or out and expands or contracts that balloon. Nor is it a water balloon that is expanded by pouring in “liquidity.” Prices are not driven by the amount of money that buyers “put in” or sellers “take out” (as those dollar amounts are identical). Prices are determined by the relative eagerness of the buyer versus the seller.

If a dentist in Poughkeepsie is willing to pay up 10 cents to buy a single share of General Electric, the total market value of General Electric increases by over $1 billion (GE has 10.28 billion shares outstanding - do the math). In this way, market capitalization can be created and destroyed out of thin air and on the smallest of trading volumes. So you'd better be sure that the there is a sound and fairly reliable stream of expected cash flows backing up the value of the securities you're buying.

Cash does not ever find a “home” in a secondary market. Every time you hear the phrase “investors are putting money into…” or “investors are taking money out of …” or “money is flowing out of … and into …,” it is a signal that the speaker is unable to distinguish a secondary market from a primary one.

As I used to teach my students, if Mickey sells his money market fund to buy stocks from Ricky, the money market fund has to sell some of its T-bills or commercial paper to Nicky, whose cash goes to Mickey, who uses the cash to buy stocks from Ricky. In the end, the cash that was held by Nicky is now held by Ricky, the money market securities that were held by Mickey are now held by Nicky, and the stock that was held by Ricky is now held by Mickey. There may have been some change in the relative prices between cash, money market securities and stocks, depending on which of the three was most eager, but there is precisely the same amount of “cash on the sidelines” after that set of transactions as there was before it.

Stocks go up and down based on the eagerness of buyers and sellers.

It is a great fallacy to say "the stock market is worth $1 trillion" or any other number.

If I am the only buyer for a particular issue on a particular day, even if I only buy one share, I can move the entire market capitalization for a company with my purchase price.

Does that mean that the company is 'worth' whatever new market value I personally just established for it?   Nope.

The "cash on the sidelines" myth could be re-stated and it would be slightly more accurate.  If I were to take a swipe at it, that would be, "The more cash people have the more eager they tend to be as buyers of stocks."

But this is not always the case and long stretches have gone by in history where people did not eagerly rush towards stocks no matter how much cash they had kicking around.

At any rate, it is important to think of the stock market in accordance with how it really operates and the secondary market is always, each day,  a zero sum game (except for temporary market maker positions which are neutral over a slightly longer time frame) with buyers and sellers canceling each other out at every moment.

 

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Woodman
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Re: Question about the role of money on the sidelines in ...
DavidLachman wrote:

...  Now imagine a situation where there is a lot of money on the sidelines, everyone has sold off and their brokerage accounts are full of dollars and they are waiting to get back in, they have money on the sideline.  ....

 Is it as simple as this:? for every person who sold off someone else bought; i.e., the cash they put into the market went to the seller.  So the total amount "on the sidelines"  didn't change. 

 

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cat233
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Re: Question about the role of money on the sidelines in ...

Well David, I guess Chris took care of that for us.  I will still listen to what he had to say on the podcast once again.  I was in NYC when the market took a dive in October.  I talked with a market maker and we discussed what Chris mentioned at the end of his reply.  They (the company the market maker worked for)  had to buy stock when they wanted to be selling stock to ... "make the market."  It was a fascinating time to be in NYC.

Cat

 

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DavidLachman
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Re: Question about the role of money on the sidelines in ...

Thanks Chris and everyone else,

So cash on the sidelines is meant to imply there are more eager buyers than sellers, which would have an upward price effect if it were true, but there is no telling what the eagerness of buyers is based on their cash position at any moment.

 

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cat233
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IPOs
Sour stock market stalls initial public
offerings
The struggling stock market is even hurting companies
that haven't gone public yet.

The initial public offering market, an important source of
cash for young companies that are eager to grow, has virtually shut down as
shell-shocked investors shy from enterprises that lack a solid performance
record.

There were just 43 initial public offerings last year, down
from 272 in 2007 — and making 2008 the worst year for IPOs since 1978,
Renaissance Capital says.

The immediate future isn't much brighter: There are no IPOs
planned until mid-February. There were at least 10 IPOs each January over the
last three years.

The frozen IPO market has made it especially hard for
certain businesses to expand:

•Start-ups. Lenders often are reluctant to lend to
new ventures and, if they do, require high interest rates. So getting locked out
of the stock market is a double hit, says Paul Bard of Renaissance Capital: "It
places pressure on growth companies."

Venture-capital firms. Venture capitalists often
sell companies as IPOs to raise cash for new investments, says Jay Ritter,
professor of finance at the University of Florida. VC investments already
started to slow in the third quarter of 2008, falling 8.9%, to $7.1 billion,
from the same quarter in 2007, says the latest data from the MoneyTree. "If this
(IPO drought) is protracted, it could be quite serious," says Josh Lerner of
Harvard University.

•Investment banks. Banks collect hefty fees when
they take firms public — and those are vanishing at a time when Wall Street is
trying to restructure. "The investment banking staffs are cut way down," says
Francis Gaskins of Gaskins IPOdesktop.

There's a chance that the IPO drought will help in the long
run. VC firms are funneling cash into companies they own that have the best
chances, making them stronger, Ritter says.

Meanwhile, investors are getting solid returns on shares of
the few IPOs getting done, Bard says. For instance, shares of the last company
to go public, education firm Grand Canyon Education, are up 70% from their
first-day closing price in November.

Companies meanwhile are getting ready for the IPO window to
open, says Ernst & Young's Maria Pinelli. Investors will be receptive to
large and established firms that go public, similar to Visa, which tapped the
IPO market last year, she says.

"Sitting in the (IPO) pipeline does not mean business is
shut down," she says.

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