The Bubble is in Cash, Not Stocks…

We are repeatedly reminded by many so-called “experts” that the stock market is in a bubble, and that when central bank quantitative easing programs end stock markets will “crash.”

However, it would appear that the only bubble is people’s uncertainty of the future and their desire to hold large sums of cash. These high cash levels equate to a huge pool of marginal buyers, rather than sellers, for stocks and other “real” assets.

With more buyers than sellers the most likely next big move for stocks is up, not down. This will be the case until equity markets are overbought. Thus, until that time we should not concern ourselves with any material downside.

One of my guiding “mantras” is a quote from the famous value investor John B. Templeton:

Bull markets are born in pessimism, grow in skepticism, mature in optimism, and die in euphoria.

If one can simply identify where we are on this continuum then everything else falls in place! Yes, it does seem simple, but the hard part is interpreting the data and sentiment to discover where we are. In order to do this one needs to have been through a few market cycles to know what conditions of optimism and euphoria are all about.

I started trading in the mid 1980s and I have been through everything between now and then. Yes, it has been one hell of a ride. However, courtesy of this “journey” I know what optimism/euphoria is all about (thank the TMT bubble for that) and what all previous market tops had in common.

Contrary to popular belief the common trait wasn’t that they were expensive, rather it was that too many people owned stocks. Markets reach stages where they quite literally run out of buyers and that is when they are prone to significant downside movements.

So let’s have a look at a few indicators which will shed light on how the market is positioned – i.e. the “ratio of weak to strong hands”. Previous market tops were characterized by high levels of consumer confidence. Granted no one indicator is perfect and free of “noise”, however, it does seem that once the Conference Board Consumer Confidence Index reaches the 110 level the market is in danger of serious downside and investors should be very cautious of being over invested in stocks. Note where the index currently sits – right bang in “neutral” territory.

Consumer Confidence Index

Yes, it is difficult to comprehend but, if consumer confidence is anything to go by, we are probably only half way through the current bull market! This may seem a wild assertion but it is backed up by what investors are doing with their savings.

When optimism is high people feel certain about the future and as a consequence they invest a high proportion of their savings in the stock market. High levels of fear/uncertainty or a lack of confidence is associated with a high proportion of peoples’ savings in cash or equivalents.

This week I couldn’t help but notice the following article in the Washington Post on 18 July:

Washington Post

The first paragraph of the article reads:

Americans are holding more cash in their bank accounts than they have at any other point over the last two decades, a new study found. The average checking account balance reached $4,436 at the end of last year, nearly double the average balance of $2,100 seen over the last 25 years, according to a new report from Moebs Services, an economic research firm. Prior to 2003, checking account balances pretty much hovered around $2,000, according to the report.

Cash levels more or less the highest in a generation! This isn’t “typically” the sort of condition that occurs anywhere near the end of an equity bull market! The same tone of this article was echoed by the following on Yahoo Finance on 21 July:

Yahoo Finance

However one looks at it – cash is still a way more popular investment alternative than stocks: released the results of a new survey about how secure Americans feel about their personal finances compared with 12 months ago. According to the results, Americans overall chose cash as their favourite long-term investment. In fact, 1 in 4 Americans prefer cash investments for money they will not need for at least 10 years. Stocks came in third with 19% of the vote.

Nearly 40% of 18-29 year-olds say cash is their preferred way to invest money they don’t need for at least 10 years, despite the fact that the S&P 500 has gained 17% over the past year while the yield on cash investments is below 1%.

Getting back to Templeton’s quote “bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria” – if these articles and the Consumer Confidence index are anything to go by then we are nowhere near a condition of optimism perhaps at best we are still in skepticism!

Yes, it is very hard to comprehend this given that the S&P is up well over 100% in some 5 years but we should be very careful of jumping to the conclusion that the stock market and sentiment move in a lockstep or linear fashion. I think that many investors are under the mistaken belief that the performance of the stock market translates directly to sentiment.

You might be asking – how has the stock market managed to advance as dramatically as it has over the last 5 years? I think to a large extent this has been driven by corporate buybacks. Many companies have been aggressively buying back their own stocks over the last 5 years which has dramatically reduced the liquidity of stocks to trade. So with liquidity in shares being dramatically reduced it doesn’t take much in the way of buying pressure to push prices higher.

This leads us to a very interesting situation and looming disaster for those who aren’t invested in stocks! Consumers (who are ultimately the buyers of stocks) have the highest cash levels in a generation, combined with the liquidity of stocks that is probably the lowest in a generation and you have the recipe for the best is yet to come in the stock market. Yes, the rally in stocks is likely to continue for many months and the performance may well rival what we have seen over the last 5 years!

– Brad

“Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart.” – Alan Greenspan


This Post Has 3 Comments

  1. Dawid Ciężarkiewicz

    Average American household debt $117,951
    Average credit card debt $2,200

    The $4k does not look really big. And this number might come from a lot of people cashing out from stock market, other being too cautious to buy on top of the bubble. For cash holders there is nowhere to invest, bonds are junk, stocks are ridiculously expensive. As long as inflation is low, there’s no reason to force cash out of your account.

    So, while I’m really interested in this theory, I don’t find it convincing.

    1. Bastian Brand

      First of all, I like the approach taken and the language is articulate and easy to read. Everything sounds convincing, but I have some theoretical questions. (Unfortunately there is no email to reach the author directly, so I post it here.)

      -> if you take the aggregate of the economy, how should people sitting on cash, not willing to spend it, change the total dollar amount of cash/checking accounts? Remember: If I spend money, my checking account goes down, but the one of the seller goes up! Alternative theory: M1 is solely driven by lending policy of banks. By the way, A doubling of cash balances over 25 years represents no more than roughly a 3% increase yoy (72rule: 72/25=3%). Hardly impressive.

      -> financial theory says that the value going out of the company (because money is spent on buying the shares) equals out the anti-dilution of a share buyback. So, on a theoretical level, a share buyback should not drive prices. I know everybody thinks otherwise, so the effect you describe may exist, but only because it is a self-fulfilling prophecy.

      To end on a positive note, the data on consumer confidence are interesting and indeed, seem to prove that we are not in bubble territory.

      Thanks for the thought provoking article.

  2. TommyD

    It seems that the bubble in cash is showing up on corporate balance sheets and higher income savings accounts. I would say the average American/European/Asian is not sitting on a tremendous amount of cash (as a definable “bubble”). The market is being driven up by cash coming in from very large fish, the small fry are far too frightened. I agree with the author, the stock market is not overvalued and should continue to rise.

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