A Quick Liquidity Update
(February 4, 2010)
Dear Subscribers and Readers,
The European Commission's response to the financial crisis in Greece has been quite muted so far. When Eastern Europe hit the skids last year, the IMF filled the void not with a vengeance – but with a determination to avoid the criticisms that were directed at the agency during the Asian Crisis. Now that Greece finds itself in a similar bind, the European Commission has chosen to do nothing (so far) other than providing psychological support. After dipping earlier this week, CDS spreads in Greece, Portugal and Spain widened yet again – as Spain projected a larger-than-expected fiscal deficit for the next three years while Portugal had to par back their bond sales for lack of demand. CDS spreads hit 400 bps for Greece, 200 bps for Portugal, and 150 bps for Spain. None of the PIIGS countries could devalue their currencies to lure investors or to boost exports. Worse yet, as mentioned in last weekend's commentary, none of these countries has been competitive on the global markets for a long time now. Neither do any of these countries offer so-called 21st century jobs.
The U.S. Dollar Index has done very well in 2010 so far. In the short-term, the Euro is oversold but over a three-year timeframe, it does not really matter, as there are only three viable scenarios for the PIIGS countries: 1) Devalue the Euro, 2) Use German taxpayers' funds to bail out Greece, Portugal, and Spain, 3) A combination of 1) and 2). Letting Greece go and severing them from the Euro Zone is obviously out of the question. As it stands, the Euro is looking a lot like the Thai Baht in December 1996. The financial dilemma in Greece needs to be resolved - it may take three months or six months but it will be resolved and it will get worse (at least for the Euro) before it gets better. This is why I believe (as we discussed in our December 30, 2009 commentary) 2010 to be a “transition year” as the global financial markets become more selective and re-price risks across the board.
As the financial crisis in Greece, Portugal, and Spain continues to spiral out of control, investors will no doubt get spooked. Financing will be harder to get for highly leveraged companies, while many individuals (or whole countries) will find it increasingly difficult to borrow to finance their consumptions. While this scenario does not bode well for the stock market in the short-term, it is not just “good medicine” for the long-run, but a good development as the marginal corporation goes out of business (thus leaving the survivors to pick up more market share, accompanied by higher profit margins) and as the citizens of Greece, Portugal, and Spain are forced to become more productive (thus making a great contribution to the global economy). In the meantime, however, the ongoing financial crisis in the PIIGS countries (along with similar troubles in U.S. commercial real estate and potentially monetary tightening in China) fits in well with our correction scenario. While the current rally could possibly last another week, the lack of a serious correction since early March 2009 – combined with an extremely overbought condition in the stock market coming into the correction – suggests that this correction has further to go.
The short-term liquidity situation supports this view. For example, the amount of "investable cash on the sidelines" versus the S&P 500 market cap has come down dramatically since the February 2009 peak, as shown in the following chart:
As can be seen in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has been making new rally lows, although this has risen a little bit in January (to 39.44%). While this ratio is still high from an absolute standpoint (especially compared to its historical record from January 1995 to December 2007), it has definitely come down too far, too fast. Probability supports a continuation of the current consolidation phase in the market, unless: 1) A major central bank announces a new liquidity facility (the prime candidate would be the Bank of Japan), or 2) a major technology (one that could speed up U.S. productivity growth) is commercialized over the next several months (which is not likely).
In addition, the amount of cash as a percentage of total assets at equity mutual funds has just hit a new low as of month-end December 2009, as shown in the following chart:
The last time that equity mutual fund cash levels has been this low (3.6%) was September 2007 – just one month prior to ultimate peak of the October 2002 to October 2007 bull market! However, cash levels may have risen since the end of December, as ICI recently reported that equity inflows in January (as of January 27th) were over $12 billion (equating to about 0.24% of total assets at equity mutual funds). Nonetheless, this number remains low and is thus not conducive to a more sustainable rally at this time.
Conclusion: With the financial crisis in Greece, Portugal, and Spain still on many investors' minds, and with the U.S. stock market still at neutral to overbought levels in the intermediate term, the U.S. stock market most likely remains in a corrective phase. For now, the market is likely to rally another week. Overall, I expect this correction to last another four to six weeks (or until our intermediate term technical/sentiment indicators get oversold), with strong support for the Dow Industrials in the 9,500 to 9,800 range.
Henry To, CFA