Cash on the Sidelines...and Rotation...

Part 2 of the Market Myths and Misconceptions Series

Part 1: The Follies of Averages...

"There's still a lot of cash on the sidelines, which is why I think markets could still move higher…”

- Brent Shutte (Chief Investment Strategist, Northwestern Mutual, 2/13/2020, 2 weeks before an epic stock market crash)

“How do I know that’s not a bunch of ones with a twenty wrapped around it?”

- Vinny Gambini (My Cousin Vinny, 1992)

Finding a good quote for this topic was actually very difficult. Not because there were so few to choose from but because there were just too many! Take any market pullback in history and you have a gaggle of strategists, analysts, fund managers, and other paid salesmen on financial TV and other media outlets trying to convince everyone to put more of their money into stocks. You would think some deep analysis based on hard data and numbers would be provided to help state their case, but that is usually not what you get. It is much easier to pull out the old reliable “cash on the sideline” excuse like Mr. Schutte did with the above quote (not to pick on Mr. Schutte, he just ranked high on my Google search). Unfortunately for him, the market crashed 30% in the following weeks after his call for a higher market due to all the “cash on the sidelines”. For someone in that position with a large financial firm that manages assets for investors, I would call that irresponsible at best. Of course we don’t want people falling for these tricks, which is why we are writing our 'Market Myths and Misconceptions' series of articles. Let’s get down to busting this myth!

This old “cash on the sidelines” myth has always been a fascinating claim to me going back to when I started in the business in 1998. I can even remember joking about it with my fellow co-workers in the Brokerage Trading dept. every time we saw someone on CNBC talking about it. I have heard and read this line so many times over the years, especially during early 2000 as the market just started to crumble with the Nasdaq in its early stages of a nearly 80% drawdown over the following two years. It was heard daily during the 2008 market meltdown and oddly enough, I recall people using this “cash on the sideline” excuse in the real estate industry at the peak of the housing bubble trying to justify how house prices wouldn’t go down(??). There is always this mythical cash ready to pour into the markets at any time according to the “experts” as their nerves start fraying during these various market events. You heard it during every correction and in fact, you heard it even as markets moved higher! The line was probably used during the flash crash of 1962, which happened in late May, a few days before the album The Sound of Johnny Cash was released. There was never a time when cash couldn’t show up to support prices. You would think this urban Wall Street myth would be fully busted by now, but it is all too alive and well! There is always that magical leprechaun named ‘Cash’ waiting to jump in and save the day! Well, if only that were the case…

The number that we see from the OFR (Office of Financial Research) is about $5 trillion of “cash” on the sidelines in money-market funds. Most of this is in Government-backed money-market funds and tends to be corporate/institutional holdings vs. retail holdings. This cash, according to the commentators, is always about to “come into the market” and drive stocks higher. The problem with this claim is that all securities issued, including a base dollar must be held by someone at all times until the security is retired (John Hussman, Ph.D, "Cash and Credit - Implications for the Financial Markets", 2/28/2011). If you have $100k sitting in cash, you personally do in fact have cash on the sideline. Suppose you take that $100k and decide to put it into a stock (we will use AAPL @ $170). You can buy 188 shares of AAPL with your cash. What happens then is that someone else must sell their 188 AAPL shares to you. The seller now has the cash from the sale and you own the shares of stock (minus the cash). No net cash came into the market, it just moved. This seems simplistic and it is, as this applies to all securities traded, including bonds, dollars, gold, etc. To take it even a step further, your “cash” is really a pool of IOU’s such as Treasury Bills, commercial paper, and other short-term debt instruments since that is what the money-market funds tend to own. When you sell your money-market fund (cash) to buy stock, the money market fund has to then sell those debt-instruments to someone else, possibly to another money-market fund that has to buy them. As you can see, the cash always exists, it just moves around to different holders. It is mathematically impossible for the cash to move into the market (an exception to this is an Initial Public Offering (IPO) which is the issuance of new shares which does pull new cash into the market). If equity markets are falling, it does not mean cash is leaving the market, which is the common assumption. It just means investors' risk appetite has fallen and they are not as willing to pay up for a risky asset causing the price to fall. If risk appetite is high, investors are willing to pay more for a stock and the price moves up. It did not move up because more cash came in off the sidelines nor did it move down because cash moved onto the sideline. Everything just got moved around, at a higher, lower or the same negotiated price.

This also brings up the often-stated term we hear equally as much if not more. That term is “rotation”. When we have a day where the bond market is up strongly and stocks are down, you will read and hear commentators suggesting that investors are “rotating” from stocks to bonds. Well, just like the magic leprechaun that is supposed to always appear with a wad of cash, this is also a fallacy, and the same principle applies. Rotation from growth to value, cyclicals to non-cyclicals, tech to defensives, large-cap to small-cap, etc, they are all narratives that are used to try to justify what is happening in markets. While someone can certainly rotate out of stocks and into bonds in their personal account, it cannot be done on a net basis. All securities/shares must be owned by someone! They cannot be locked in the briefcase and thrown out of the car window as you drive across the bridge in the middle of the night (hmm, maybe you could do this back when physical shares were issued). If someone is “rotating” out, someone else must “rotate” in!

I hope you enjoyed this brief dive into the “cash on the sideline” and “rotation” myths. I think we might need to get Vinny Gambini on the case and put these “strategists” on the stand to question their claims. My guess is Ms. Mona Lisa Vito would be able to explain how this works much better than most of these “experts”…

- Eric

The Follies of Averages...

Part 1 of the Market Myths and Misconceptions Series

“…the average depth of the river is only 3 feet so I can walk across it!”

- drowning statistician as he hits the part of the river that’s 10 feet deep.

“…the stock market goes up about 10%/year on average”

- nearly every Financial Advisor at their first meeting with a prospective client.

When I was deciding on whether to attend the University of North Dakota back in the mid 1990’s, I remember that in addition to researching their aviation and flight school programs, I thoroughly researched what the historical average temperatures were in North Dakota during the winter months. After attending school in Florida for a short time, this was a daunting move, but being that they had one of the most well-respected aviation programs in the country, it seemed worth the torture of heading north to freezing cold weather for a couple of years. I am not so sure that looking at the average temperatures did me any good in this case. Seeing that Grand Forks, ND had an average high temperature of 20 degrees during February was not pleasant, but nothing that an extra couple of layers and some heated socks couldn’t handle. What was even more unpleasant is that Grand Forks ended up having the coldest winter in recorded history while I was there. I experienced -39 degrees and if you want to factor in wind chill, it hit -65 degrees one lovely evening. This is something you should only experience on an expedition to Antarctica, but I was lucky enough for it to happen during my last semester of college. So much for that ‘average’ February temperature of 20 degrees.

I always liked working with averages in math class but I did not like it as much when it came to my Statistics class in college. Statistics taught me that averages were, well, not always as they seem. Start throwing in standard deviations, means, modes and medians…my grade point ‘average’ goes down. This is also true in the financial industry where averages are almost everything, especially when it comes to performance metrics and advertising. But are they really what they appear to be?

Let us take a hypothetical example of a mutual fund that shows the following annual returns over the past 3 years. Which one of these Funds would you be more likely to invest in?

Fund A: Year 1 Year 2 Year 3

86% -37% -19%

Fund B: Year 1 Year 2 Year 3

-15% 15% 30%

Each of these funds tells a different story but both of these funds would in fact show their annualized 3-year return for the period to be 8%. Does that mean you earned 8%/year? Not at all. In fact, if you started with $100k in Fund A at the beginning of the 3 year period, you would now have less than you started with! You would end the 3 year period with approx. $95k, a loss of 5%. In Fund B, you would end with approximately $127k, a gain of 27%. Two different funds with wildly different annual performance numbers but both reporting identical 3-year performance numbers. This is an example of how one outlier year can skew the entire performance metric. Average returns rarely happen in real life when it comes to your own money. They are much more common when it comes to financial marketing.

This takes us back to the very misused quote about stock market returns. The average return of the Dow Jones (DJIA) is often stated as 10%/year. This is a true number and is in fact a true 'average' over a very long period of time (approx. 100 years). But as shown in our example above, average return does not mean compounded return! It's a very misleading assumption and many financial plans are based on this flawed method of using these assumed ‘average' returns that are grossly elevated. I saw a proposal from another firm that simply forecasted making 9%/year for the next 20 years with a comment underneath the very large ending balance saying "Congratulations...you did it!!". Oh my...

I think back to the 1999-2000 timeframe that many of us can remember quite well…for better or worse. I recall the numerous people that were just entering the market during one of the most epic stock market manias in history. Many would take their 401k savings at retirement and go to a financial advisor who was anxious to get another hefty commission payout by selling some B-share mutual funds. The advisor starts showing the most recent returns from 1999…”The xyz Technology Fund is up nearly 100% this year and the average 3 year return is 48%/year!”. Many bought in. Others would decide to invest on their own since it seemed so easy to make money and those performance numbers being advertised are fantastic! Hey, if the E-Trade baby on TV could do it...so can I! Unfortunately, for those that decided to invest during this moment of time, they were in for quite an awakening. After the collapse of the Nasdaq, it would take 15 years to get back to even. "Pick Up The Pieces" by the Average White Band would have been an appropriate theme song for the time. But wait, they said the market averages 10%/year?

I recall the numerous Technology funds that were able to advertise their 1999 performance number for many years after the collapse since it boosted their ‘average’ annualized returns. One very popular Technology mutual fund at the time had the following annual return numbers:

1999 2000 2001

101% -34% -41%

The 3-year average annualized return reported by the Fund at the end of 2001 would have been shown as 8.7%/year. Did you make 8.7%/year? Well, if you had invested at the very beginning of the 1999 period, your return after 3 years, including doubling your money during the first year would have been -22%. Those darn averages...

The 100%+ returns that so many Tech funds had in 1999 looked spectacular, but in the end, it was only spectacular if you were invested in the fund ONLY during the year of 1999. Afterwards, it was more like being in Grand Forks, ND during the winter of 1996…

P.S. These 'Follies of Averages' were also implicit in one of the largest economic collapses in history in 2008 when the assumption that house prices always went up about 6% a year on 'average' caused many "experts" to be blindsided by the housing crash...but that's a story for another article perhaps!

- Eric

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