Of Hydrogen and Stupidity

It’s been said the two most common elements in the universe are hydrogen and stupidity; and stupidity has a longer half-life.  Not being a scientist, I’ll withhold comment on the 1937 zeppelin reducer.  Sitting in an office that plays CNBC all day, however, I can certainly attest to the widespread availability of stupidity.

This is the channel featuring pundit after pundit bleating out priceless nuggets like “at the end of the day, ” “fiscal cliff, ” and “wall of worry.”  If it weren’t for the cliché’s (and the constantly running ad in which a guy dramatically impales his eardrum with a Q-tip) the programming day would be about 90 minutes long.

But, during those 90 minutes, we’d be treated to some of the most repeated and inaccurate comments imaginable.  During the past few weeks, the topic du jour has been a listing of the reasons the market rally will continue.

 1.      “There is a ton of cash on the sidelines.”

This is commonly cited as a catalyst for increasing stock prices.  While there may be 2, 000 pounds of cash on the wrong side of the chalk line, its existence alone is… well… meaningless.  To make the point, follow this example:

Let’s assume that the entire stock market is made up of three people.  Here are their current holdings:

  • Andy holds $450 in cash
  • Billy holds $451 in cash
  • Carl holds 1 share of Apple (AAPL)

That means our market contains $901 in cash and 1 share AAPL.

Both Andy and Billy want to buy a share of AAPL.  Carl sells his share to the highest bidder, Billy, and collects $451.  Once the trade is completed, our investors hold the following positions:

  • Andy holds $450 in cash
  • Billy holds 1 share of Apple (AAPL)
  • Carl holds $451 in cash

$901 remains on the “sidelines” and 1 share of AAPL rounds out our market.

Look familiar?

There is an identical amount of cash on the sidelines after the transaction as there was before the transaction.  The only difference is that the holders of the sideline cash have changed.

What matters is not solely the amount of cash available for investment (with the exception of initial and secondary offerings), but the velocity in which the cash moves from person to person.  In other words, inflation in security prices is driven by the same factors that drive overall economic inflation:  

Money Supply x Velocity = Inflation

 As our national economy is illustrating so well, money supply can be increased indefinitely, but if velocity is zero, inflation is zero.  Stock prices are driven higher when a group of buyers look to increase the velocity of the cash they hold.  As velocity increases per unit of cash, prices inflate.

  2.      “Retail participation in the stock market is far below what it was in the 1990’s.”

While this statement is unquestionably accurate on its face, the implication that the participation deficit creates room for the markets to grow is misleading.  Here’s why:

  • Baby Boomers:  People born between 1946 and 1964 are typically defined as Baby Boomers.  In 1999, the oldest Boomers were 53 and the youngest were 35.  Arguably, this giant population bulge was smack-dab in the middle of the investment phase of their lives.  Presently, that population spans ages 49 to 67.  At that age demographic, particularly post-crisis, it is likely that the Boomer appetite for equities has diminished at least as much as their appetite for Big Macs.
  • Generation X:  people born during the 1960’s and 1970’s constitute this class.  Gen X arrived at the investment phase of their lives right between 2000 and 2010.  From January 2000 through January 2013, the stock market (S&P 500) has delivered a 0.15% annualized return with two major collapses (the worst being 52.6% peak to trough).  This is a generation that has never seen wealth accumulated via the stock market, yet they witnessed the near collapse of the global financial system.  Many lost their jobs as a consequence.    Convincing this generation that buying stocks is a good idea is a very tall task, indeed.
  • Pensions:  In the 1990’s, defined benefit pension plans were prolific – assuring a steady and predictable flow of cash into equity markets.  In the 20-odd years since, defined contribution plans (like 401(k)’s) have become a much larger share of the retirement savings market.  Participation in these plans is voluntary and the allocation to equities is up to the individual investor.    This problem is compounded with high unemployment and low participation rates constraining the number of plan participants.  Circling back to Gen X, it is unlikely we’ll see contribution levels like those that existed in the 1990’s.
  • Lower levels of personal wealth:  After the financial crisis and housing collapse, personal net worth in the aggregate has taken a massive hit.  And while the stock market has regained all of its 2007 – 2008 losses, it is unlikely that equity investors’ en masse held on through the bad years in order to fully participate in the recovery.  More likely, they sold out on the way down and failed to reinvest on the way back up.

 The evidence?

 There is a ton of cash on the sidelines.

  3.       “We are witnessing a rotation out of bonds and into stocks.”

This is the first derivative of “There is a ton of money on the sidelines.”  In the interest of time, I won’t go through the entire example, but here is how it sets up:

  •  Andy holds $450 in cash
  • Billy holds $451 in cash
  • Carl holds 1 share of Apple (AAPL)
  • Dave holds 1 Treasury Bond

No matter who sells what to whom else, the owners change but the market remains the same.

 

If I’m forced to hear these memes too many more times, I may very well impale my own eardrums…  if for only the sake of my sanity.

 

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