January of 2012 was a heck of a month, at least for stocks. The S&P 500 gained a hefty 4.3%, and the market’s up more than 17% from its October lows. Yet, there’s been a notable lack of volume on the way up. One could put the question this way: Where did all the money go?

There are two potential ways to interpret that — and they’re diametrical opposites.

The bullish theory is the simple assumption that the lack of volume thus far means there’s still a truckload of “cash on the sidelines” ready to flood the market and send it rocketing higher. The bearish interpretation is that any money that was available (and was going to be invested) has already been placed, and there just isn’t anymore waiting to go to work. Thus, what little strength we’ve seen in stocks so far is now going to be winding down.

But there’s even a third theory, and it suggests that the continued growth of the exchange-traded fund industry has quietly garnered all this alleged “cash on the sidelines.” Like with the bearish theory, this means that cash is already in the market and can’t be used to buy again.

Don’t scoff at the idea. We truly may be at the point where we can say money being locked up by ETFs is keeping money out of direct investment in individual stocks. If that’s the case, things could continue to get even tougher for the overall market.

Before we write the obituaries though, let’s look at some measurable trends.

Numbers Don’t Lie

Just to put things in perspective, the biggest energy ETF is the Energy Select Sector SPDR (NYSE:XLE), with a $6.72 billion market cap. Its top two holdings are Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM). They make up 15.2% and 19.2% of the fund, respectively, or roughly $2.3 billion worth of the two stocks.

That’s not an alarming problem because Exxon boasts a market cap of nearly $400 billion, and Chevron is a $205 billion company. Surely $2.3 billion worth of the two giants isn’t too much for one institution to own, right?

Well, no. But it’s not just one institution that owns huge chunks of these companies.

The sum total of assets held in ETFs devoted explicitly to energy and oil assets is around $25 billion. Assuming the same proportion of XOM and CVX are held by each, all of a sudden $10 billion worth of $605 billion in market cap is held by one industry.

And let’s not forget the market’s biggest index funds, like the SPDR S&P 500 ETF (NYSE:SPY). That’s now a $100 billion fund, 5.4% of which is made up of Exxon Mobil and Chevron. That’s another $5.4 billion worth of the $605 billion market cap of the combined companies now off the table for other investors. How many other sizable index funds are hogging more shares of the market’s biggest companies? Answer: About another $100 billion worth, when adding up all the rest.

And more ETFs are constantly being launched, numbering in the hundreds every year now. Each of them takes another hunk of the effective float for all major stocks off the table.

Past the Tipping Point?

The potential problem is no longer a concept, but a reality: The effective, liquid float — and perhaps more important,  any real reason for investors to need or want individual stocks — is starting to shrink. Traders aren’t looking to buy XLE and CVX; they’re looking to buy XLE or CVX. And increasingly, they’re opting for the fund over the stock.

It’s not like these fund managers are likely to let go of these stocks and put them back into the open market anytime soon, either. Indeed, their percentage of individual stock ownership is only apt to increase as time moves on, based on history.

Though not to the same degree as mutual funds, which buy and sell stocks every day in accordance with investors’ buying and selling of the fund, exchange-traded funds do build (and occasionally redeem) so-called creation units on a fairly regular basis, as demand merits. “Creation units” are just big, and identical, blocks of stocks that act as an ETF’s underlying assets. While most retail investors never see them or know about them, the ability to expand a fund by increasing the number of creation units allows ETF sponsors to accept “new” money on an ongoing basis.

And they have.

In 2011, a little more than $100 billion of new cash went into new – and existing — ETFs, which is on pace with “new money” levels poured into the ETF industry in 2010, and even 2009. That brings the total amount of ETF-managed assets to a little over $1 trillion. Though some of the funds’ holdings are foreign stocks, the bulk of them are U.S. names. And the U.S. is the biggest single source of ETF demand.

Compared to the total $17.21 trillion market cap of U.S. listed stocks, it doesn’t seem like much. Keep in mind, however (and as was said already), ETF sponsors generally don’t let go of any stocks once their fund owns them, because there’s little need to sell shares. Even the institutions see little reason in redeeming ETF shares in exchange for the underlying stocks. So, while it’s not impossible to think the underlying stocks held by funds could be released, odds are good those holdings are — for the most part — locked up.

Here’s the thing: It wasn’t just a January phenomenon. Cash displacement from stocks to funds has been a problem for a while.

Despite forward progress during some of the time between then and now, the market’s overall volume started to noticeably dwindle in March of 2009. It was the first time in decades volume started to slump for any reason, but to see volume dry up during a rally? That’s a major red flag.

Although it’s not the only possible reason for fading volume from one month to the next since early 2009, the volume decline suspiciously jibes with the heaviest/fastest phase of ETF creation yet. If it’s just a coincidence, it’s a major one.

Conclusion

The explosion of ETFs still doesn’t fully answer the question “Where did all the money go?” (see Part 2 for the rest of the answer). But the growth of the ETF industry may mean there’s at least a little less cash on the sidelines right now than we’d all like to hope. If you’re counting on a sudden inflow to make for a bullish 2012, it may not happen, at least to the degree you’re expecting.

Don’t throw in the whole towel just yet though because there’s more to this story. . .

As of this writing, James Brumley doesn’t own any of the securities mentioned here.