Bank Lending and Liquidity Update
(March 11, 2011)
Dear Subscribers and Readers,
In our February 25, 2011 commentary (“Is the Shadow Banking System Recovering?”), we asserted that while CMBS and ABS originations are starting to “hum along” again, both bank lending and private equity lending still remain depressed and dysfunctional. The Fed is trying to revive bank lending and economic growth through the purchases of US government debt, but there are still no signs of a revival in bank lending. Over the intermediate to long run, such a revival is essential to a sustained uptrend in asset prices and US economic growth. Following is a monthly chart showing the state of U.S. bank lending—i.e. the year-over-year change in loans and leases by held by U.S. commercial banks for the period January 1949 to February 2011 (updated to February 23, 2011):
While the decline in bank lending in 2009 was unprecedented (unless one cites data from the Great Depression—when one-third of all US banks failed), it has steadied in the last 12 months. Note that while bank lending growth has risen back to the zero line, we are not out of the woods. In fact, the absolute amount of bank loans and leases outstanding (seasonally adjusted) has actually declined by $98.5 billion (to $6.70 trillion) from the end of September 2010 to February 23, 2011. The lack of liquidity creation within the U.S. banking system does not bode well for the short-term outlook for the stock market. In fact, we believe the current correction has should last for several more weeks.
Let's now shift to a discussion on liquidity. As I am penning this, insurance shares in the UK have declined anywhere from 1.5% to nearly 5.0% due to the 8.9-magnitude earthquake in North Japan. Depending on the extent of the damage and casualties, this could have an adverse impact on liquidity—at the very least, the Bank of Japan would need to ease liquidity further. For now, let's take a quick look at 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. At the end of February 2011, it declined to cyclical bull market low, but has since perked up due to the recent stock market decline, 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 declined to a cyclical bull market low of 28.39% at the end of February 2011(its lowest level since the end of December 2007). It has perked up over the last 10 days, however, given the stock market decline in March so far. More important, has declined too far, too fast, and is very low compared to its readings over the last three years. The low readings in this liquidity indicator suggests that the correction will continue for the foreseeable future.
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 January 2011 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 mutual fund cash levels has lingered at 3.5% in December and January—and matches the low of 3.5% in July 2007—near the peak of the last bull market. Despite the recent inflows into equity mutual funds, I would not be surprised if cash levels at equity mutual funds remain at 3.5% in February. We will continue to take a wait-and-see approach to the markets, and believe the current correction has more room to run. 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