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Liquidity (Slightly) Improving

(August 17, 2011)

Dear Subscribers and Readers,

Our base case for the U.S. and global stock markets is still one of listlessness, at best, or a larger correction going into the end of summer/early fall.  While many commentators are noting the “death cross” (the 50-EMA of the S&P 500 crossing below its 200-EMA), subscribers should keep in mind that not all such “death crosses” result in a full-blown bear market.  More often, the first “death cross” (or whatever you want to call it) in a cyclical bull market is a head-fake.  In the meantime, the official surveys are still showing somewhat bullish sentiment among individual investors.  Combined with low cash levels at equity mutual funds, the ongoing European Sovereign Debt Crisis, and the general reluctance of the world's central banks to inject primary liquidity, we still believe that the market hasn't reached a sustainable bottom.  Should the Dow Industrials decline below 11,000 again, however, we will seriously think about initiating a 50% long position in our DJIA Timing System.  Note that there is significant support in the 10,000 to 10,500 range should the market embark on another correction.

We continue to believe that the Fed should restrain from implementing QE3, as discussed in last weekend's commentary.  However, there is no doubt that the ECB would need to keep buying Spanish and Italian sovereign debt to keep these two countries afloat, until a more permanent debt reduction (or sharing) mechanism could be agreed upon.  Meanwhile, the Bank of England is now seriously considering another QE policy—perhaps towards the end of this year or early next year.

In the meantime, U.S. financial liquidity has steadily improved.  While this is likely not sufficient to prevent another market correction, this steady improvement is very promising from a longer-term economic standpoint.  As we mentioned, none of our leading indicators (general liquidity, the stock market, corporate bond yield spreads, the ECRI Weekly Leading Index, the Ceridian-UCLA Pulse of Commerce Index, etc.) are even close to signaling a recession.  This is our primary thesis, and we are sticking to it.  Let us now review our U.S. financial liquidity indicators.

Since our March 25, 2011 commentary (“Update of the Shadow Banking System”), the amount of ABS originations has improved significantly, especially on a global basis.  That is—despite more tightening by emerging market countries and the ongoing European sovereign debt crisis—access to liquidity has improved, especially for consumers tapping into auto loans, credit card loans, and student loans.  Following is a chart showing global issuance of asset-based securities for last year and this year on a YTD basis (courtesy of Asset-Backed Alert):

That said, this “recovery” in global issuance of asset-backed securities remains very vulnerable, as no doubt the asset-backed market will “freeze up” again should the European sovereign debt crisis get out of hand (i.e. if Italian 10-year yield rises above 6.5%).  From a domestic standpoint, both the Fed and U.S. commercial banks thus need to play a big role 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 1950 to July 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 15 months.  Bank lending growth, while still negative on a year-over-year basis, is now only down 1.1% (compared to -2.0% in June).  In fact, the absolute amount of bank loans and leases outstanding (seasonally adjusted) rose by $4.0 billion (to $6.77 trillion) from the end of December 2010 to end of July 2011.  While such liquidity creation within the U.S. commercial banking system does not improve the stock market's short-term outlook, it does represent a slight improvement on a longer-term basis.  With both the “shadow banking system” and the general banking system now experiencing slight improvements, the prognosis for the U.S. economy has improved slightly.  All that remains now is for the ECB and potentially the Bank of England to do their jobs and inject more liquidity into the global financial markets.

Signing off,

Henry To, CFA, CAIA

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