The fuel is there--but where (and when) is the match?

07/12/2010 12:28 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

It’s called fuel for the next rally. But it’s better first to think of the money piling up on the sidelines as water building pressure in a pipe.

In the week that ended on Wednesday July 7 more money flowed into money market funds—and out of other financial assets such as stocks than in any week since January 2009. (Do I need to remind you what happened in March 2009? The market bottomed and set off the second greatest relief rally in U.S. stock market history.

Money market funds took in $33.5 billion in the week, according to EPFR Global. The United States accounts for about two-thirds of the money market funds that EPFR tracks.

The week also saw about $420 million flow into commodity funds as traders sought the safety of gold and other precious metals.

The money in money market funds is earning 0.5% or less—in some cases much less.

That’s only an acceptable yield as long as fear stays high. And the longer that money sits on the sidelines the harder it is for money managers to accept that kind of yield, safety or no safety. So think of this stage of the market as analogous to water building up in a pipeline behind a cork. At some point the pressure becomes impossible to resist and the water breaks lose. Money flows into markets—any sort of market—in search of something better than a 0.5% yield.

Now under the right conditions that flood of cash under pressure ignites financial markets. (Think of it as a flood of gasoline if my mixed metaphors are making you crazy.) The flood of cash in search of better returns drives up prices, leading more cash to slow into the market, driving up prices some more.

The cash that had been on the sidelines becomes fuel for the next rally.

But it doesn’t have to work that way. The flood of cash may drive up prices for a brief while—but only long enough to meet a new flood of worries. The two waves meet and the cash flows wash back toward the sidelines as temporary gains turn into slight losses that raise fears that bigger losses are to come.

So yes, a buildup of cash on the sidelines is necessary for the start of another rally—and in that sense the data is cause for optimism. But the buildup of cash isn’t sufficient. By itself it’s not enough to create another rally. That will require an end—or at least a temporary resolution—to the worries about euro debt, the European banking system, growth in the U.S. economy, and growth in the Chinese economy.

We could see the tide of worry start to turn in late July with the European banking stress tests due on July 123—if they’re reassuring rather than worrying. Good macro economic data from the United States and China on second quarter GDP growth and positive trends in the U.S. employment market and in Chinese exports would be necessary next steps to turn the pressure into fuel.

And it might take markets until September or October to get comfortable in those areas.

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