Market Liquidity Updates
(May 12, 2011)
Dear Subscribers and Readers,
Overall, general global liquidity remains tight. Recently, the Reserve Bank of India hiked its policy rate by a more-than-expected 50 basis points last week, while the rest of the BRIC countries continue to tighten their monetary policies by a combination of rising required reserve ratios and hikes in policy rates. The tightening in global liquidity is having a significant impact in the Euro Zone, as Greek bond yields rise to a new high, and as Finland remains apprehensive about “bailing out” Portugal. As the Fed's QE2 policy winds down (with no sight of further loosening by the Fed)—and as other central banks continue to tighten—this put significant pressures on commodity prices as well. For example, both crude oil and silver prices had their biggest declines in recent years last week—although it was not surprising given the amount of speculation in these commodities.
Let's now shift to a discussion on U.S. market liquidity. One measure is 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. Since its February 2009 peak, it has declined very quickly. As of the close yesterday, it sits near 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 been consistently declining since February 2009. The ratio temporarily bottomed at the end of April 2010, with the ratio rising by 3.99% from the end of April 2010 to the end of August 2010 (from 32.57% to 36.56%). However, with the stock market rally since the beginning of this year, this ratio sits near a cyclical bull market low of 28.52% as of yesterday at the close (its lowest level since the end of December 2007). More important, it 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's upside is limited for the foreseeable future and highly vulnerable to a sizable 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 3.4%) as of the end of March 2011 is equal to its all-time low of 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% from December 2010 to February 2011 (matching the low of 3.5% in July 2007—near the peak of the last bull market)—and as of the end of March, declind to a record low of 3.4%! Despite the recent cash inflows into equity mutual funds, cash levels likely remains low. We will continue to take a wait-and-see approach to the markets, and believe a correction is inevitable.
While general global liquidity is still tight, however, we're now seeing some revival through direct liquidity creation by the Bank of Japan in response to liquidity pressures generated by the March 11th earthquake. After following a relatively “non-activist” monetary policy for the last several years, the Bank of Japan is finally delivering. From the end of March to the end of April 2011, the year-over-year increase in the Japanese monetary base increased from 16.9% to a whopping 23.9%, as shown in the following chart:
While this latest increase is highly encouraging, subscribers should note that historically the Bank of Japan has tightened liquidity relatively quickly post any exogenous shock. In other words, the latest easing is probably just sufficient to cover short-term liquidity needs by the Japanese banking system—and may not be sufficiently high enough to sustain a more robust recovery. Given all-around global tightening, subscribers should continue to be cautious. Indeed, while the Dow Industrials and the S&P 500 could continue to make new highs in the face of deteriorating technicals, it also means the market is increasingly vulnerable to a deeper-than-expected correction. We are going out on a limb: Should the Dow Industrials and S&P 500 continue to rally (preferably to over 13,000) on dismal upside breadth and/or volume, there's a good chance we will go short in our DJIA Timing System.
Henry To, CFA, CAIA