Summary
- As the rally in the S&P 500 happened, approximately $1T of money moved to the “sidelines”; that is, into money market funds.
- Of that $1T, about 20% was from retail investors and 80% from institutional investors.
- This is not what we have seen in previous recessions. Normally when money moves to the sidelines the S&P 500 goes down.
- One could argue that the money that is on the sidelines would be coming in to take advantage of pullbacks, as the new money that came in earlier is taken out to fuel consumption. Some of these pullbacks could be severe.
The March-June 2020 rally in the S&P 500
The figure below shows the rally in the S&P 500 during the March-June 2020 period. The index has gone from approximately 2,237 to 3,055; up about 36%.
We used the charting feature of Yahoo Finance (
). The slow-moving line is the 52-day moving average.
About $1T moved to the sidelines
As the rally in the S&P 500 happened, approximately $1T of money moved to the “sidelines”; that is, into money market funds. This is illustrated by the figure below, with charts from FRED (
). Of that $1T, about 20% was from retail investors and 80% from institutional investors.
The top chart shows the growth in money market funds from retail investors. For example, if an individual investor with an account on E-Trade (i.e., a “retail” investor) sells a stock position, that money typically will go into a sweep account tied to a money market fund. The bottom chart shows the growth in money market funds from institutional investors.
So, both retail and institutional investors moved a lot of money to the sidelines. This is not what we have seen in previous recessions. Normally when money moves to the sidelines the S&P 500 goes down.
Many people would interpret this as money leaving the financial markets, in absolute terms. This is not what happened. For each stock sale there must be a corresponding purchase. If investors on the sidelines are buying, and sellers are moving to the sidelines, there should be no significant change the in the total amount held by money market funds.
If investors are selling to raise cash, and stock prices are going up, there must be “new” money coming into the stock market at a higher rate than the rate at which investors are selling.
The Fed’s balance sheet grew by $2T during the rally
As you can see in the figure below, the Fed’s balance sheet grew by about $2T during the rally. It grew $3T from February. That is partly what fueled the rally.
This new money that has been “created” by the Fed takes some time to make its way into the hands of people who can buy stocks. So, what we are seeing here is the beginning of something interesting; a rather rare occurrence.
What does this mean? The bull case
One could argue that the money that is on the sidelines would be coming in to take advantage of pullbacks, as the new money that came in earlier is taken out to fuel consumption. Some of these pullbacks could be severe, because newcomers may be parking money in stocks as they would with a bank account - with money that they need to pay for recurring expenses.
This should propel the stock market higher after each pullback. The increase in consumption caused by the money coming out of the stock market may give the impression that the economy is recovering by itself. The ensuing optimism would push stocks even higher.
But the impression that the economy is recovering would be a mirage, at least early on. This highly volatile bull market would be largely driven by the liquidity injected by the Fed. The volatility would be triggered by mixed headlines; e.g., consumer confidence is up, but so is the government deficit.
We could see something like the S&P 500 reaching 4,000 amid a wave of bankruptcies! Not all companies will go bankrupt, of course. For each local “Supa Burger” that goes bankrupt, there will be a bit more market share for the local McDonald’s and Burger King competitors.
Active investing may shine brighter than passive (index funds) in this scenario. Active investors have to think about a number of issues, such as how failures in one industry can benefit leaders in another. As a Hertz goes bankrupt, Uber may benefit. (Disclosure: the author owns shares of UBER at the time of this writing; and also of MCD and QSR, for the references above.)
What does this mean? The bear case
It is hard to see a scenario where this new money printed by the Fed, the portion available for stock purchases, will all go to the sidelines due to pessimism. Money market accounts are paying very little, because Treasury yields are so low. Investors are compelled to put the money somewhere. The stock market is one of the only options.
It is not hard to see a scenario where inflation will grow due to an increase in money supply, even as GDP contracts. Inflation is bad for fixed-income investing, making Treasuries even less attractive, but inflation is not necessarily bad for stock investing. At least not while inflation is growing but is still relatively low (e.g., low single digits).
This creates a positive feedback loop for stocks!
However, this is a bad scenario if maintained for too long, which could bring about severe economic strain, and another major drop in the stock market. High inflation would eventually prompt the Fed to increase interest rates, without a robust economy to compensate for that tightening if GDP is contracting.
But this bad scenario may take a few years to materialize.
