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THE FACT THAT THERE'S CASH ON THE sidelines is a handy, if slippery, argument for why the stock market could get a further boost.
Handy because money-market-fund assets as a percentage of U.S. stock-market value is well above the long-term average, suggesting that the public remains disdainful of equities. Slippery because (due mostly to rising stock prices) the ratio is way below the historic high it reached early in 2009 -- and because there's never a guarantee that cash that could be redeployed into stocks actually will be.
It's possible, however, that this isn't even the most salient pile of cash on the most important sideline. Better to watch whether the cash held by large companies, the ultra-wealthy, bond funds and private-equity firms is mobilized.
If the Federal Reserve and other central banks are following a strategic plan, now that the system has been stabilized with various props, it involves-by one interpretation -- smothering market volatility with cheap money.
The Fed seems to believe that it is acting as something akin to a fire company soaking a still-hot, burned building after the flames have been extinguished. The heat is volatility. Critics who now loudly accuse the Fed of creating new market bubbles-with the Dow where it stood a decade ago and oil at half its peak price, no less-are effectively complaining that the central bankers are making the building too wet.
The notion is that only when market volatility, and expectations of it, recede and things appear a bit more predictable will the keepers of the cash use it for long-term purposes such as capital spending, hiring, acquisitions and investing in new issues to help recapitalize the system.
The option market's VIX indicator is tightly related to corporate credit costs. It has bounced around between 20 and 30 for some time now -- by many lights a still-elevated level, given the upward march of the indexes and the relative rarity of dramatic declines. Credit-market improvement has been the single biggest driver of broader financial-market recovery. Corporate-bond funds are choking on all the money being thrown at them by retail investors too skittish for stocks, and by institutions seeking a fairly secure return. Whether there's much value in high-grade bonds after their huge run is quite debatable. But that there's an appetite for them is not.
At last report, says the Investment Company Institute, corporate-bond funds had 8% of their assets in cash, a level not approached since the mid-1990s. This sidelined cash should help anchor credit spreads (with absolute rate levels, in turn, being anchored by the Fed's invisible short-term rates).
The key driver of sturdy profit margins and rising 2010 earnings forecasts has been the husbanding of cash and compressing of expenses by big companies. This has been widely sneezed at by market skeptics, but the kind of productivity surge that was reported this month for the third quarter is typically followed by a similar jump in output.
And, remember, the equity market doesn't directly capitalize the condition of the median or average household or the mood of the typical mall walker or job seeker, but rather the profit streams of mostly large, appreciably global, companies. For a certain limited stretch of time, corporate recovery can suffice for markets to hold up.
Henry McVey, head of global macro and asset allocation at Morgan Stanley Investment Management, believes that large companies can defend their margins, in part by forcing price cuts from smaller suppliers. This would enlarge advantages of scale, lend credence to forward S&P 500 earnings estimates and dampen inflation.
The argument over whether the profit rebound for next year has been bought and paid for with the rally to 1100 in the S&P-just as the 2004 profit party was celebrated mostly by the end of '03 -is one worth having. Retail investors might, as some suggest, stay more heavily exposed to cash than in the past. But under more stable conditions, it's hard to imagine that CEOs will spurn growth and empire-assembling. This would mean a quickening of the nascent merger-and-acquisition recovery, more aggressive capital-spending programs and-yes- expanding headcount.
A lot would have to break right for this to play out as the money masters hope. But don't be surprised if, in a year, there's a bit less cash on the sidelines.
E-mail: michael.santoli@barrons.com
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