Intro: There are several misunderstandings with regards to the interaction between wealth and equity markets, so-called cash on the sidelines, and role of buybacks in supporting stocks. It is key to remember that equity market wealth is represented not by current equity prices but the stream of future cash flows that investors can expect their securities to deliver over time.
Cash on the Sidelines
It is often said that high levels of ‘cash on the sidelines’ are bullish because it provides potential for these investors to put money into the stock market, boosting stock prices. However, there is no logic to this analysis whatsoever. For every dollar that moves into the stock market, a dollar moves out of it. For every buyer there’s a seller. Equity prices rise not because there is more money going into the market, but because buyers are more eager to buy than sellers are to sell. When equity markets decline analysts often talk about money flowing out of the market and into other assets. However, in aggregate when stocks fall the ‘money’ simply vanishes into thin air. Let’s say that the S&P is trading at 3,000 and suddenly there are fears of a recession causing investors to want to sell stocks. As the demand to sell overwhelms the demand to buy, prices fall and paper ‘wealth’ evaporates, without actually going into any other assets.
Equity Prices and Wealth
Financial commentators often talk about equity market crashes ‘wiping out wealth’. However, real wealth is embodied in its ability to create goods and services via the use of land, labour, and physical and human capital. A rising equity market can reflect a rise in real wealth (although does not necessarily have to) but it is a distinctly different thing. An equity market crash does not destroy wealth, it reflects a reduction in expectations of real wealth creation and thus a reduction in expectations of real future earnings and dividends payments.
The Role of Buybacks
Many investors see buybacks as a major source of equity gains. When companies buy back their shares, this reduces the amount of shares outstanding which raises the share price for any given value of market capitalization. However, most buybacks are used to offset dilution from stock and option grants to corporate insiders, and not a major source of equity market gains.
Don’t Fight The Fed
This is one of the best-known market adages even after the global financial crisis saw US stocks fall by 55% amid the most aggressive easing cycle the Fed has ever conducted. While it is true that all else equal easy monetary policy does provide support to equity prices, other factors can overwhelm the positive impact. Specifically, when valuations are extremely expensive and market internals are deteriorating, money easing does little to prevent investors from heading to the exits.