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The Myth of 'Cash on the Sidelines'

NEW YORK (TheStreet) -- For the past few years many market pundits have been talking about the vast sums of cash investors are "keeping on the sidelines."

The argument, with which I'm sure you are familiar, goes something like this: "Investors are holding vast sums of money in cash on the sidelines that will eventually find itself into the market and help drive asset prices higher."

While there is nothing wrong with the statement above, it is incomplete.

First of all, the levels of cash on the sidelines are by most accounts only about 20% higher than historical norms -- on an inflation-adjusted basis. In other words, while cash levels are elevated, they are not immensely higher than one would expect.

In my view, these cash levels are justified and appropriate given the current overall market and economic conditions. As a Registered Investment Advisor and someone who runs a money management firm, I (we) typically advise clients have at least one year's worth of expenses set aside for emergencies -- set aside in cash! Depending on your lifestyle and income, that can easily come to $100,000 or more.

In other words, that cash is there for very specific strategic financial reasons and is unlikely to move.

More significantly, on a "net" basis, cash holdings -- as an asset class -- are actually down and by some accounts in negative territory. To grasp why this is so, it helps to remember that "cash" refers to not only actual hard cash but also "cash equivalents" and customers' credit balances in their margin accounts.

So, while current cash and equivalent holdings sit around $288 billion (comprised of $128,676,000,000 in cash and equivalents and $159,520,000,000 in credit balances in margin accounts), current margin debt is just under $466 billion. That's right, there is more margin debt than cash. Hence, on a net basis and in aggregate, investors have a negative cash position.

As the chart below illustrates, margin debt is has risen along with the S&P 500, matching historical trends.

It's important to remember is that the level of margin debt does not tell us much about the direction of the market, as such I am not viewing the current high levels of margin debt as a bearish indicator. However, I do think it counters the argument that investors have a lot of "cash on the sidelines" and that this cash will eventually find itself into the market.

What I suspect will really happen is that as interest rates rise and equity returns moderate, the cash will be used to lower margin debt.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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