The One Reason the Rally Will Continue -- Debunked

Cash on the sidelines. There is $3.4 trillion parked in money market funds right now earning virtually nothing, just waiting to flood back into stocks. I'm certain you've heard this in support of the notion that the stock rally has legs (I even referred to it back in August). Unfortunately for bulls, as Goldman Sachs (NYSE: GS  ) strategist David Kostin pointed out in a recent note to clients, investors are misinterpreting this figure, and the argument is vastly overstated.

What is true
There is undoubtedly a relationship between flows in and out of equities and money market funds. For example, it's no coincidence that money market fund assets peaked during the same week in March which saw the S&P 500 hit a 12-year low. As investors sold equities, they parked the proceeds in cash equivalents.

Where the argument goes wrong
Conversely, the bull argument goes, as risk appetite returns, investors will move back into stocks, drawing down their money market accounts to do so. It should be clear from the numbers in the table below that if investors were to move all of their cash from money market funds into stocks, it would light a fire under the stock market.

 

Total Value (at Oct. 28, 2009)

Money Market Mutual Funds

$3.37 trillion

U.S. Equities (Proxy: Wilshire 5000 Total Market Index)

$12.28 trillion

Money Market Funds as a % of Total U.S. Equities Market Value

27%

Source: Investment Company Institute and author's calculation, based on data from Wilshire Associates.

However, there are limits to this reshuffling. Kostin expects taxable money market fund assets to fall to $2 trillion in 2011 from $3 trillion at the end of October. Even those numbers overstate the potential impact on stocks, since part of these outflows will move into bond funds.

Looking back to 2003
Data from the Investment Company Institute, an industry group, show that in 2003, the year stocks rebounded after a debilitating three-year stretch, total net flows out of money market funds totaled $258 billion dollars -- just 2% of the current total capitalization of U.S. equity markets.

Finally, I'd add that risk appetite looks like it's peaking, if it hasn't already peaked. The market's rally has left the S&P 500 overpriced, and the valuations of certain stocks look stretched:

Stock

Forward P/E* (Next 12 Months' Earnings)

% Price Return From March 9 Market Low*

Wynn Resorts (Nasdaq: WYNN  )

91.1

261%

Amazon.com (Nasdaq: AMZN  )

52.1

96%

Ford (NYSE: F  )

48.6

328%

Yahoo! (Nasdaq: YHOO  )

35.6

24%

Bank of America (NYSE: BAC  )

31.9

295%

Whole Foods Market (Nasdaq: WFMI  )

31.5

173%

*At November 3, 2009.
Source: Capital IQ, a division of Standard & Poor's.

Eventually, value will out
I don't know whether the stock rally will continue -- it could well do. However, it's important not to accept bullish (or bearish) arguments uncritically, particularly in an environment in which stocks are already overvalued. After all, value always exerts its own momentum ultimately.

As we emerge from the recession, this is exactly the time to buy these stocks.

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Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Amazon.com and Whole Foods Market are Motley Fool Stock Advisor picks. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


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