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Saturday, August 15, 2009

The "Cash On The Sidelines" Myth

I'm a fan of Dr. Ron Sen's blog, because he, like me is not a financial professional, but unlike me, is pretty damn sharp. He also introduced me (via his links) to several people who are professionals, including John Hussman. One of the common reasons bulls give for being bullish (when fundamentals say otherwise) is the "cash on the sidelines" argument. that is, people who are holding a lot of cash are looking for a place to put it, and when they put it in the stock market, naturally all that cash will drive prices up. That makes sense at first glance, but it never passed the "smell test" for me. I couldn't put my finger on what was wrong with it, until i came across a Hussman article from March of 2007. Here, in one paragraph, he blows the argument out of the water with a very simple exlanation:

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.

When money goes into a secondary market, there is just as much money coming out. That is, when new buyers come in, they are buying from someone who is selling. It is only when new shares are issued that new money comes into the market. Prices can also rise due to reduced supply, as we saw in the spate of mergers and takeovers during Spring and Summer of 2007. But when supply is steady, then prices will rise only if buyers are willing to bid up prices. there will still be just as much money going out as coming in.

So next time you hear Kudlow talking about "cash on the sidelines", you will have one more reason to call him an idiot.

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