WHERE DOES ALL THE MONEY “FLOW”?

You often hear about money “flowing” into and out of bonds and stocks.  As if the owner of a bond can just throw it in the garbage can and decide to buy stocks with that same money.  Of course, that’s not how it works.  On any secondary market all securities are always held by someone.  This is an important concept that is too often overlooked.  Money never really flows out of bonds and into other asset classes except during new issuance. On a secondary market securities are merely exchanged.  After all, this is why they call it a “stock exchange”.  I raise the topic currently because John Hussman described this important concept in his latest weekly letter.  In it, he described the situation that has confused many investors regarding QE:

“Suppose that investor A has $100 in a bank account, and decides to move that money “into the stock market.” Investor A goes to the stock market, and buys some number of stock certificates from investor B. Investor B now gets a claim on the $100 of bank reserves, and the stock certificates formerly owned by investor B are now owned by investor A. Investor B might now choose to buy Treasury bonds with the proceeds. When all is said and done, investor A will own stock shares previously owned by investor B, investor B will own Treasury bonds previously owned by investor C, and investor C will have a claim to bank reserves previously owned by investor A. Money has not gone “off the sidelines” and “into” stocks. Previously issued securities have simply changed ownership, and those securities will remain outstanding until they are retired.

Now suppose the Federal Reserve comes in and buys the Treasury bonds held by investor B. Investor B now gets some newly created bank reserves. Somebody has to hold them. Regardless of whether investor B holds them directly, or investor B makes a trade so that someone else holds them, those bank reserves have to be held by someone until they are retired. The extent to which these reserves will affect the prices of goods, commodities, stocks or anything else is determined by whether investor B is satisfied to hold the bank deposit. If not, investor B may bid up the price of some other good or asset by just enough that some other marginal holder is satisfied to trade their asset for the cash, but there is certainly no reason for the resulting change in prices to be proportional to the change in the quantity of bank reserves.

From this perspective, what is presently occurring in the stock market is that investors who were previously satisfied to hold stocks at lower valuations have been induced to transfer those shares to speculators who are now satisfied to hold those stocks at rich valuations. One has to ask who the smart money is in this trade.

So money never goes “into” or “out of” a secondary market. Investors can never “sell bonds” and “buy stocks” in aggregate. Nor can they use their “sideline” cash to buy stocks, in aggregate. Whatever funds are on the sidelines in money market assets such as short term debt instruments must, in equilibrium, stay “on the sidelines” until those instruments are retired. What moves prices is not the amount of money moving “into” or “out of” some market, but the relative eagerness of demand versus supply.”

With regards to QE the best way to think of what the Fed has done is to say that they have traded a 5 year bond with a 1 day note (reserves).   This does not create some new fuel for the seller of the bond.  After all, these reserves have to be held by someone just like the 5 year bond had to be held by someone.  So, you can see that the buying power in the market has not changed at all.

What the Fed had hoped to do via QE was increase the attractiveness of risk assets by reducing interest rates.  This would supposedly increase the risk premia on stocks and entice buyers.  Instead, interest rates have surged and the popularity of the Bernanke put has grown infinitely.

While any contribution to rising risk asset prices is certainly psychological (and not fundamentally due to QE) it’s interesting to note that this psychological impact has taken on a rather nefarious tone.  Like the Greenspan Put, investors are now convinced that equity prices will not be allowed to decline.  While the Fed may have had good intentions with regards to QE it is increasingly worrisome that a positive psychology is developing around this strategy.  As I wrote back in November, the only thing scarier than QE failing is QE succeeding…..