L.E. Memo | A Share Bought is a Share Sold
And other fun things to say on the internet.
Cash, short of burning it, which creates fiduciary risk, cannot be created or destroyed.
- Mike Green
Pity thee who disagrees with Cliff Asness on the internet but the concept of “money on the sidelines” continues to be widely misunderstood. It seems that a key source of the aphorism is a fun article Asness published in the Financial Analyst Journal in 2014 titled “My Top 10 Peeves.” It is a study of market colloquialisms, heuristics, and myths that Asness takes to task with his trademark efficiency and wit. Number 5, a collection of common phrases, includes “It’s a stock pickers market,” “arbitrage,” and “There’s a lot of cash on the sidelines” that Asness wishes were permanently retired.
Every time someone says, “There is a lot of cash on the sidelines,” a tiny part of my soul dies. There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.
If you want to save those who say this, I can think of two ways. First, they really just mean that sentiment is negative but people are waiting to buy. If sentiment turns, it won’t move any cash off the sidelines because, again, that just can’t happen, but it can mean prices will rise because more people will be trying to get off the nonexistent sidelines than on. Second, over the long term, there really are sidelines in the sense that new shares can be created or destroyed (net issuance), and that may well be a function of investor sentiment.1
But even though I’ve thrown people who use this phrase a lifeline, I believe that they really do think there are sidelines. There aren’t. Like any equilibrium concept (a powerful way of thinking that is amazingly underused), there can be a sideline for any subset of investors, but someone else has to be doing the opposite. Add us all up and there are no sidelines.
What seems most at issue here is a variety of semantic distinctions that are not entirely trivial. Of course, Asness is right at the very practical level that the units of exchange in every trade are equivalent, but I don’t believe those that refer to the overall level of cash allocations are suggesting otherwise. Similarly, Asness’ first “lifeline,” that they are referring to sentiment, also seems to miss the implication of an aggregate change in demand for risk assets. Liquidity needs and time horizons can impact the relative risk appetite of investors as much or more than their bullishness on equity prices. His second lifeline, the creation or destruction of financial assets is actually crucially important. What if the supply of financial assets is structurally low and sticky— in economics parlance, “supply inelastic?”
Stocks and Flows: the Inelastic Market Hypothesis
The issue at hand is that many refer to a “stock,” the amount of cash in money markets/cash equivalents to make an inference about the impact of a “flow,” a rate of change, movement, or activity. The flow portion is the critical element of investors, in aggregate, shifting their demand to risk assets. In a more academic understanding of the market, investors are making assumptions about fundamental value when they transact, and those fundamental assumptions are reflected in asset prices. While asset prices are noisy over short time frames, and many models account for liquidity in a micro sense, there is a core belief that stock price movements are reflective of investors’ shifting attitudes toward the future (the net present value of cash flows).
Xavier Gabaix & Ralph S. J. Koijen introduce an important alternative to this assumption in their June 2021 paper “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis.” According to the hypothesis, financial market fluctuations occur mainly because the supply of financial assets is relatively inelastic, meaning it does not quickly adjust to changes in demand. In other words, when there is a sudden increase or decrease in demand for assets, the market cannot instantly create or eliminate these assets to match the new demand, leading to price changes.
We start by asking a simple question: when an investor sells $1 worth of bonds and buys $1 worth of stocks, what happens to the valuation of the aggregate stock market? In the simplest “efficient markets” model, the price is the present value of future dividends, so the valuation of the aggregate market should not change. However, we find both theoretically and empirically, using an instrumental variables strategy, that the market’s aggregate value goes up by about $5 (our estimates are between $3 and $8, and we will use $5 for simplicity in the theory and discussion). Hence, the stock market in this simple model is a very reactive economic machine, which turns an additional $1 of investment into an increase of $5 in aggregate market valuations.
This is admittedly obtuse to understand in a theoretical or general sense, but when viewed in the context of the rise of passive investing, it becomes clear that while a “stock bought” may indeed be a stock sold, the clearing price of that transaction is subject to a previously unconsidered constraint.
Mike Green’s Ode to a Burning Urn of Cash
No one has been more vocal in calling into question the impact of passive investing than Mike Green of Simplify Asset Management. I briefly covered some of Green’s views in Like A Pro:
Prices are a little bit like Schrodinger’s cat, they tell you where something was on the last transaction, but they don’t actually tell you what the price is, right? The price could be up, it could be down. We don’t know that until the next transaction occurs. Passive is assuming that they’re not having any influence on that next price but they have to be because they are transacting
On his Substack2, Green has done a great job of illustrating, in more practical terms the impact of a dollar moving from cash to the market. Green does so in the context of funds shifting from active vehicles, which hold more cash (~5%), to index vehicles which hold almost none (17bps), but the impacts of leaving money markets to re-enter the market are nearly identical.
The statement that is obviously on the lips of skeptics, “OK, so active managers average 5% cash, and passive managers only hold 17bps of cash. Big deal. Markets go up 5%.
This is a misunderstanding and sits at the core of the problem. Cash, short of burning it, which creates fiduciary risk, cannot be created or destroyed. If active managers are redeemed and replaced with passive managers who want to hold less cash, the ONLY solution is for equity prices to rise.
Why? Green has an excellent illustration, but as dollars move over to passive, the passive fund needs to find a market of sellers to get back to their target cash level.
Note that it’s not a solution to have active managers sell $9.50 AND passive managers buy $9.99. That is not a transaction, as buying does not equal selling. To arrive at a solution, we must solve iteratively for where buyers are equal to sellers. As a result, equities appreciate by more than 1% for a 1% allocation to passive.
Beyond our traditional understanding of liquidity, dollars entering the market are increasingly finding an absence of discretionary sellers. These impacts are still in their early phase, as Green points out, passive represents a sizable (45%) but not yet a majority of market assets.
So, is a share bought a share sold? Yes, but the transaction is not as simple as the academicized exchange described by Asness and others. The discussion itself reflects a common challenge in finance discourse wherein the realism of market structures and incentives runs increasingly counter to theoretical notions of value. The inverse also holds. Aside from a logical hypothesis on the impact of passive market actors, can their impact be empirically proven? Massive one-day changes in the value of the largest companies in the index seem to be at least indicative of something new occurring.
While Gabaix & Koijen focus on the supply side of financial assets, another group of researchers at UCLA identified that demand too is inelastic, leading to a decrease in overall market efficiency. Simply put, “not enough people are showing up to trade. You have less information in the market, less aggressive trading, less accurate prices and a more volatile market.” In such an environment, with growing cash balances, a potential reversal obviously has price impacts that go well beyond what can be explained by “sentiment.” The philosophical or practical existence of sidelines, or of people proverbially leaving them, is shorthand for a broader shift in risk appetite hitting an equity market with increasingly less capacity to meet the demand.
Emphasis mine, throughout