The Money On The Sidelines Fallacy

on July 31 2009 5:13 PM

It seems these days any time a pundit is cornered by facts indicating the deplorable state of the economy, the traditional fall back is ...but the tons of money on the sidelines is just waiting for a 0.003% pullback to pour back in.

It makes sense to consider this argument.

I present Exhibit A: a chart of the Net Wealth of US Households. This is defined as the total amount outstanding in U.S. money market Funds and the total market cap of U.S. listed stock. All else being equal, one can see why the administration is so concerned with the market decline impact on the psychology of the U.S. consumer: confidence is the name of the game. Net Wealth declined from a peak of $22 trillion to just under $12 trillion in early March, and now, compliments of the bear market rally, has bounced higher to $15.4 trillion, a 30% decline from the peak.

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Of course, and much more troubling, is that all else is nowhere close to being equal. When considering consumer wealth, one also has to look at the right side of the balance sheet, and as the Fed's Flow of Funds Report indicates, consumer debt has not budged, and has stayed essentially flat as the equity market: the key component of consumer wealth has gotten decimated.

Exhibit B: Total Household Debt:

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Alas it does not follow the chart in Exhibit A, not even closely. So the question is: what has been the bottom line impact on household equity: i.e., taking the debt component of balance sheet and superimposing it vis-a-vis net wealth. The result is scary.

Exhibit C: Household Equity.

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From the end of 2007 through Q1 of 2009, household equity has declined by 94%. Is it surprising that today's GDP number would have been a complete debacle if the consumer had been left alone to prop the U.S. economy, on whom 70% of the economy is reliant? Obama pulled a Hail Mary with the stimulus: without it there would be no debate America is in a depression right now. The only remaining question is how long can Congress and Senate extend such Subsidy programs as Cash for Clunkers before the rest of the world throws up in America's protectionist face.

But back to the money on the sidelines.

Exhibit D indicates the historical progression of the market cap of U.S. listed stocks versus money held in Money Market accounts.

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What becomes immediately obvious is that the positive correlation between equities and money markets was purely driven as a result of cheap leverage. As households used up their rapidly appreciating homes as HELOC-based piggy banks, they invested in the market, only to see that capital get destroyed while putting more and more cash away in safe (well, safe only until a global run on money market accounts occurs, such as the one that was barely avoided on September 19th of 2008) places such as money markets. Most interesting is the correlation between Money Market totals and the listed stock value since the March lows: a $2.7 trillion move in equities was accompanied by a less than $400 billion reduction in Money Market accounts!

Where, may we ask, did the balance of $2.3 trillion in purchasing power come from? Why the Federal Reserve of course, which directly and indirectly subsidized U.S. banks (and foreign ones through liquidity swaps) for roughly that amount. Apparently these banks promptly went on a buying spree to raise the all important equity market, so that the U.S. consumer who net equity was almost negative on March 31, could have some semblance of confidence back and would go ahead and max out his credit card. Alas, as one can see in the money multiplier and velocity of money metrics, U.S. consumers couldn't care less about leveraging themselves any more.

The truth is that money market accounts, which currently hold about $3.6 trillion dollars, will not decline much more, as this is the only perceived safe haven for U.S. household capital. The U.S. consumer has seen how volatile the equity market is and is unwilling to transfer substantial amounts of capital from safe to risky investment vehicles. The fact that household equity has declined by 94% is also a very critical concern. And, even if Money Market accounts get depleted and all capital moves to stocks, it is obvious that without Federal backing the market will never even get back to 2007 levels purely as a function of capital flows.

The only motive the households would have to invest more freely in the markets is if their underlying debt were to decline. And as the Z.1 indicates it has been flat at $13 trillion for over 2 years now. Of course, banks would have no interest in taking impairments on household debt as that would mean their balance sheets are solidly capitalized - a lie that is being perpetuated by the likes of the GAAP, the FDIC, the regulators and the Federal Reserve. So while U.S. consumers and U.S. banks are stuck in this vicious loop, it is foolish to make any judgments that the money on the sidelines will spark any additional rallies.

If pundits wish to find out where any new equity buying interest will come from, they need to look at the same place that was responsible for the market move over the past 4 months - the New York Federal Reserve.

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