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Still Watching Liquidity

(October 29, 2010)

Note: Sure, it uses Intel CPUs and NVidia GPUs, but that doesn't take away the fact that China now possesses the fastest supercomputer in the world.

Dear Subscribers and Readers,

As we discussed in yesterday's email, I want to start this commentary with a review of the size of the Fed's balance—that is, the amount of securities held (which include Treasuries, agency debt, and agency MBS) on the Fed's balance sheet.  Since late June, the size of the Fed's balance sheet (as per the amount of securities outstanding) has remained steady in the $2.04 to $2.07 trillion range.  As of October 27, 2010, securities outstanding on the Fed's balance sheet totaled $2.044 trillion—the lowest amount since May 12, 2010.  As shown on the following chart, the Fed had been purchasing more Treasuries as the agency debt and agency MBS on its balance sheet matured over the last several months:

Over the last 8 weeks, the Fed purchased $48.5 billion of Treasuries, as $50.0 billion of agency debt and mortgage-backed securities matured.  No real news here: The Fed has maintained its discipline and stayed true to the FOMC statements of maintaining a steady balance sheet.  Unless the Fed announced a “QE2” policy that exceeds market expectations at the conclusion of the FOMC meeting on November 3rd, I continue to expect a range-bound market, if not an outright correction.

The lack of strength in our liquidity indicators is also exemplified by the percentage of cash in equity mutual funds.  In particular, cash as a percentage of equity mutual funds' assets (at 3.5%) as of the end of September remained near its all-time low (3.4%) set as of the end of July 2010, as shown in the following chart:

Note that the current reading of 3.5% matches the low of 3.5% in July 2007—near the peak of the last bull market.  Given the 3.85% rally in the S&P 500 and the lack of cash inflows into equity mutual funds so far in October, the buying power of equity mutual funds will no doubt have decreased since the end of September.  In fact, I would not be surprised if cash levels at equity mutual funds declined back to its all-time low as of the end of October.  We will continue to take a wait-and-see approach to the markets.  I would not be surprised if the market stages a correction at the conclusion of the November 3rd FOMC meeting.  As we also discussed in latest weekend commentary, subscribers with a buy-and-hold philosophy should seriously think about hedging their long positions by going long the U.S. Dollar Index.

Signing off,

Henry To, CFA

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