Liquidity Indicators Still Challenging
(January 28, 2011)
Dear Subscribers and Readers,
While we expect overall liquidity (including bank lending, CMBS issuance, etc.) to pick up later this year, the short-term liquidity indicators remain challenging, despite the ongoing implementation of the Fed's “QE2,” the European Central Bank's purchases of European peripheral sovereign bonds, and the economic/asset boom in emerging markets. One glaring example is in the securitized markets. As illustrated in the following chart (courtesy of ABSAlert), U.S. and global ABS issuance so far in 2011 is running behind that of 2010 (and last year wasn't a great year):
A more direct measure of liquidity as it relates to the U.S. stock market—the amount of cash sitting on the sidelines (as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background) has declined very quickly since its peak at the end of February 2009. In fact, it has declined to another cyclical bull market low, as shown in the following chart:
Note that we have updated the numbers as of Thursday evening. As referenced 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 consistently declined since February 2009. The ratio temporarily bottomed at the end of April, with the ratio rising by 3.99% from the end of April to the end of August (from 32.57% to 36.56%). However, with the unstoppable stock market rally, this ratio has declined to a new cyclical bull market low of 29.03% as of Thursday evening (and is now at its lowest level since the end of December 2007). Moreover, this ratio has declined too far, too fast, and is very low compared to its readings over the last three years. This liquidity indicator is almost screaming for a 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 December 2010 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 3.33% rally (price-only) in the S&P 500 on a YTD basis, the buying power of equity mutual funds will no doubt have decreased since the end of December. I would not be surprised if cash levels at equity mutual funds declined back to its all-time low by the end of January. We will continue to take a wait-and-see approach to the markets, and believe a correction in the 5% to 10% range is imminent. With long-term technicals still flashing bullish signals (and with the Fed committed to an accommodative stance), however, I anticipate shifting from a neutral position to a 50% or 100% long position in our DJIA Timing System once we've determined that the upcoming correction has nearly run its course.
Henry To, CFA, CAIA