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Money market bulge
Big cash balance won't flow into stocks

I can't tell you how many times I've read or heard the following reasoning for bullishness: "There are record levels of cash sitting on the sidelines. The inevitability of some of that flowing into equity markets will create a significant demand for stocks - thereby pushing up prices." It has intuitive appeal but there are good reasons why I don't buy it.

Common uses of money funds

I don't know of any official stats on the most common uses of money market funds, but there are three basic uses that I've identified in my decade of industry experience. The first is for saving for large expenditures. This is usually done over a period spanning more than one year. Another is to keep a temporary cash reserve which is already earmarked for some predetermined purpose (i.e. business opportunity). Finally, many investors do use money market funds as a springboard into other types of funds or as a temporary parking spot while investment decisions are finalized.

There are surely other uses but the key is to recognize that money market funds are used in a variety of ways. Only one of those is a doorway into other investments and stocks are just one type of investment into which such funds may flow.

Reasons for rising MMF assets

There are two scenarios that can push money market fund assets to historically high levels. Weak returns of long-term funds (i.e. non money market) relative to that of money market funds will - all else being equal - decrease long term assets while pushing up money market assets.

Another scenario is simply stronger net sales (or smaller net redemptions) for money market funds will result in a rising relative asset base in favour of money market funds - again all else being equal.

Empirical evidence

Studying the last ten years of money market fund assets and net sales - relative to long-term funds - simply reveals no meaningful relationship. The two noticeable bottoms in money market assets (as a percentage of total IFIC assets) occurred in April 1998 (after which the summer 1998 meltdown followed) and September 2000 (near the peak of the share price of then index-heavyweight Nortel Networks).

Past trough levels fell between 10 and 20 percent of total fund assets, while past peak asset levels tend to be north of 30 percent of total assets. However, there are a couple of points worth making about these stats.

First, if these figures can be used for anything, it is to measure investor sentiment not potential for demand for stocks. Sure, there may be a casual observable trend between cash levels and subsequent stock returns, but the available statistics are not nearly robust enough to draw any meaningful conclusions. Plus, it's only clear in hindsight - which is rather useless.

For what it's worth, the current level of money market assets relative to total fund assets is planted just a sliver above the median average over the past ten years. So, even if you subscribe to this method, it would be rather neutral today.

Common sense

All of the above arguments notwithstanding, why would cash find its way into the stock market if the fundamentals of such market are not attractive? In other words, my point is that the fundamentals (both in absolute and relative terms) must be sound to the extent that attractive risk/reward potential exists, before a boatload of cash found its way into such securities. Plus, investors can change their minds and instead decide that the money is better spent paying down the record consumer debt levels seen in North America - which is never a bad way to lock in guaranteed after-tax returns.

In an of itself, high levels of money market funds and other cash vehicles is not necessarily related to eventual flows of funds into equity markets.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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