Bank Lending and Market Liquidity Updates
(April 1, 2011)
Dear Subscribers and Readers,
In our March 25, 2011 commentary (“Update of the Shadow Banking System”), we noted that the spike in CMBS originations in February had been temporary; and that CMBS spreads have since risen. In addition, ABS originations remain mediocre. In other words, the global “shadow banking system” remains very challenging—and thus it is up to the Fed and the commercial banks to revive bank lending and economic growth. Over the intermediate to long run, bank lending needs to revive for a sustained uptrend in asset prices and 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 March 2011 (updated to March 16, 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 to the zero line, we are not out of the woods. In fact, the absolute amount of bank loans and leases outstanding (seasonally adjusted) actually declined by $94.6 billion (to $6.70 trillion) from the end of September 2010 to March 16, 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 market is still in a correction phase that will last for several weeks.
Let's now shift to a discussion on market liquidity. I will provide an update to the Bank of Japan's liquidity provisions this weekend. 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 risen slightly due to the recent weakening stock market and a slight increase in liquidity, 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 stock market rally in the first couple months of 2011, 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 in March given the weakening market and a slight increase in market liquidity, although it is still near its bull market low. More important, has declined too far, too fast, and is very low compared to its readings over the last three years. The low reading in this liquidity indicator suggests that the market correction is not over and 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 February 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, January, and February—and matches the low of 3.5% in July 2007—near the peak of the last bull market. Last month, I stated: “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.” I reiterate the same stance this month—I would not be surprised if this ratio lingers at 3.5% or even decline further in March. We will continue to take a wait-and-see approach to the markets, and believe a correction is inevitable. Should the market continue to rally in the early parts of April, we will likely shift from a neutral to a 50% short position in our DJIA Timing System.
Henry To, CFA, CAIA