What Will Drive Markets Higher (or Lower)?

What drives the price of stocks on a day-to-day (or year-to-year) basis? What causes the price to go up or down? A lot of people talk about “cash flow”, and money flowing in and out of the market. For example, it’s not uncommon to hear snippets on the news like:

“Liquid capital could come back and fuel a rally.”

“There is a lot of money waiting on the sidelines.”

“I think there’s enough cash on the sideline that any pullback is being greeted with buying.“

But does cash really drive markets? Let’s see…

1) Say Bob has a comic book that he bought for $5, and $15 cash for buying other comic books. Jim has $20 cash for buying comic books.

	Cash	Comics	Total
Bob	$15	$5	$20
Jim	$20	$0	$20
Total	$35	$5	$40

2) Jim offers to buy Bob’s comic book for $10 because he thinks that it’s going to be more valuable in the future. Bob agrees to the price. The comic is now worth $10, and Bob makes $5 on the deal.

	Cash	Comics	Total
Bob	$25	$0	$25
Jim	$10	$10	$20
Total	$35	$10	$45

3) A few days later, Bob regrets selling the comic and really wants it back, so he begs Jim to sell it back to him. Jim reluctantly agrees, and sells it back to him for $25. The comic is now worth $25, and Jim made $15 between the two transactions.

	Cash	Comics	Total
Bob	$0	$25	$25
Jim	$35	$0	$35
Total	$35	$25	$60

4) The next day, the comic publisher announces that it will run another printing of Bob’s comic because it’s so popular. Now anyone can buy that comic for $5.

	Cash	Comics	Total
Bob	$0	$5	$5
Jim	$35	$0	$35
Total	$35	$5	$40

Notice two things:

• The total “cash on the sideline” doesn’t change. Every time a transaction takes place, cash moves, but the total cash available doesn’t change.
• The system is not a zero-sum game – it’s possible for everyone to win (or lose) at least for some period of time.

This is exactly what happens in the stock market every day. There are a fixed number of shares in the stock market (except when there’s a secondary offering, or an IPO). A rally doesn’t actually “use up” (nor require) cash sitting on sideline. Cash moves around from person to person, but doesn’t “enter” or “leave” the market except when its owner decides to reallocate that cash for some other purpose. Hmm…

So what happens when a bunch of people want to move a bunch of cash from other asset classes into the stock market? Back to the above example: if Ted has $1,000 and wants to get into the comic business, he might buy Bob’s comic for $50 (or not). His decision isn’t based on the fact he has money burning a hole in his pocket. His decision is based on whether he can buy the comic at a lower price than that at which he can later sell it – i.e. it’s all about sentiment. If Ted doesn’t believe that he can make money buying the comic at $50, regardless of how much cash he has, he’d be an idiot to pay that much for it…

The same thing happens in the stock market. The only reason to buy something is if you believe you can make money in whatever timeframe you’re looking at – it doesn’t matter how much cash you have. Prices rise when greed and optimism are prevalent. Prices fall when fear and pessimism rule the day. All cash does is provide liquidity for this to happen efficiently (“sideline” cash has actually been rising for years by the way). Don’t worry – there will always be more than enough sideline cash looking for opportunities regardless of the state of the market. The thing that changes on a day to day basis is sentiment.

So when some talking head says, “the markets will rally when cash comes into the market”, what he really means to say “the markets will rally when optimism comes into the market”.

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