Inertia is supporting continued climb for stocks

The stock market’s wild ride last month undoubtedly left a lot of investors wondering if now is the time to take some profits and head for the sidelines.

Considering the stellar run of the past five years, with the S&P 500 up nearly 140% from March 2009, it would be easy to make the case for sitting out at least the rest of the summer, just to be safe.

On the other hand, one could buckle up, take a deep breath and move against the grain, which historically is where the advantages are found.

Although that might appear to be a bold, contrarian move, there is some basic logic suggesting that inertia is supporting a continued ascent for equities. It largely boils down to a lot of cash building on the sidelines, combined with a steady reduction in outstanding stock, as companies continue to repurchase their own shares.

Because there are multiple forces preventing a rush into the markets — such as a weak economic recovery and what looks like a new risk around every corner —the equity market supply-and-demand imbalance is less likely to rebound suddenly than it is to provide a kind of floor for the market.

“PERFECT STORM’

“Because of all the talk about risk, and all the anxiety that’s out there in the markets, the potential for an equity bubble and quick snapback is mitigated,” said Matthew Lloyd, chief investment strategist at Advisors Asset Management Inc.

“The perfect storm is coming,” he said. “The fundamentals are there, and supply-and-demand is maintaining a market floor.”

The just-released 2013 U.S. Trust Insights on Wealth and Worth confirms one aspect of the cash-on-the-sidelines argument by pointing out that 56% of investors surveyed admit to having a “substantial amount of funds in cash.”

Illustrated another way, and justifying the heavy allocation to cash, the same survey shows that 63% of investors are willing to take lower returns for lower risk.

What this added up to, according to the Federal Reserve’s Flow of Funds Report, was $9.1 trillion in total household balance sheets sitting in cash or cash equivalents at the end of last year.

That compares with $5.1 trillion at the end of 2002 and $7.4 trillion at the end of 2007.

CASH STOCKPILE

Add to that cash stockpile about $3.5 trillion in cash held by the public companies making up the Russell 3000, up from $2.1 trillion in 2007.

Then there is the $2.1 trillion in cash represented by U.S. commercial-bank assets, compared with $340 billion in early 2008.

There are several other cash stockpiles that are more difficult to calculate, such as specific allocations by institutional investors and alternative investments such as hedge funds.

With regard to hedge funds, the assumptions that the category has been holding a lot of cash recently is based simply on how badly the funds have underperformed relative to equities. This year through June, for example, the Barclays Hedge Fund Index gained 4.5%, compared with a 13% gain for the S&P 500.

Last year, the hedge fund index gained 8.3%, versus the S&P 500’s 16% advance.

To some market watchers, this kind of cash on the sidelines looks like potential pent-up demand, especially when one considers the other side of the equation.

Since the first quarter of 2011, the companies in the S&P 500 have been repurchasing an average of 1.3% of outstanding stock each quarter.

“There’s plenty of cash hoarding and buybacks because companies are not hiring and they’re still cautious about mergers and acquisitions,” Mr. Lloyd said. “If companies are buying back more than 1% of their stock, you’re looking at a significant imbalance of supply and demand.”

Whether the ultimate imbalance is measured as lopsided or merely tilted, it is an unevenness supported largely by so much cash sitting idle.

And the reason it can be viewed as deliberate and significant upward support for stocks, as opposed to a more dramatic spike, is that third force known as fear.

As we saw a few weeks ago when stocks dipped a few percentage points, the market is reading — and probably overthinking — the risk associated with the eventual tapering of the Federal Reserve’s $3.4 trillion, five-year quantitative-easing program.

Obviously, a cycle of rising interest rates represents all manner of resistance to equities, borrowers, bond holders, etc. But how near are we to anything that looks like a tightening cycle?

First, at some point, possibly this year, assuming that the employment picture improves and something that looks like inflation emerges, the Fed could start dialing back on its pace of $85 billion in bond purchases per month.

Beyond that, it is anyone’s guess as to when or how the Fed will move off its policy of keeping short-term rates at zero.

“The Fed could taper — or not — but ultimately, they will continue to be accommodative, along with the rest of the globe,” Mr. Lloyd said. “Combine that with all the money on the sidelines, and risk assets are the place to be over the longer term.”

Related Topics: Federal Reserve, Investment Strategies