Our MarketThoughts "Excess M" Indicator
Below is an extract from a "subscriber's only" commentary originally posted at marketthoughts.com on 23rd October 2005.
As of October 16th, our MarketThoughts.com website has transitioned to a subscription model. This is our first commentary catered to subscribers who have moved along with us to the "new" MarketThoughts family. First of all, I want to say "thank you" for all your support. Without all of you, we would not be here and certainly won't have the motivation to write a commentary going forward. I am very optimistic going forward - optimistic on both the opportunity to learn from each other and the opportunity to reap big gains from the financial markets. Again, as I have always emphasized: Most investors should focus on the big picture and invest for the long-run. All one needs is to catch two to three secular trends or themes in his/her lifetimes, and one will be set. As always, we will be watching.
Second of all, and more important, I would like all our readers to read the Security Tips and Fraud Prevention page at Paypal. Since all of you are using Paypal to subscribe - reading this is paramount to your security going forward. I am sure most of you have read about credit card numbers being stolen, identify thefts, etc. I also bet most of you have received emails pretending to originate from Paypal at some point in time - asking you for personal information such as Social Security numbers, credit numbers, and so forth. Do not give them out and do not click on any links in those emails. To access the Paypal website, you should ALWAYS INDEPENDENTLY open your internet browser, and manually type in www.paypal.com. Again, please read the Security Tips and Fraud Prevention Page and please don't let yourself be a victim.
We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. This author is currently looking to initiate a 100% long position in our DJIA Timing System in short order - at least in terms of timeframe anyway. Bulls and bears alike: The market is still very oversold and dangerous - and so we will keep you all updated on a day-to-day basis in our discussion forum. Please login every night and we will discuss. We will also restrict access in our discussion forum to subscribers only very shortly - most probably before the end of this year.
In the last two commentaries, two of the many things that I discussed include focusing on the secular view (three to five years out) as well as finding your "edge" when it comes to trading the market. We discussed how Bill Gross gets his edge - an edge that is exclusive of his market knowledge (although that is definitely very valuable as well) - the idea of having a portfolio structural composition that is designed to generate positive alpha over the long-run. Here at MarketThoughts.com, we have always tried to maintain a longer-term view of things - as exemplified by our indicators such as the MarketThoughts Global Diffusion Index, foreign assets held in the custody of the Federal Reserve (which is a great indicator of the demand of U.S. dollars), the Philadelphia Bank Index, NYSE and NASDAQ short interest, the amount of margin debt, and so forth. That is not to say, however, that we don't discuss the week-to-week action, and I think we do it fairly by consistently keeping track of our overbought/oversold indicators, as well as the action of the Dow Industrials vs. the Dow Transports, as well as our popular sentiment indicators. Through it all, we have also always encouraged our subscribers to learn from our commentaries - since this is the true way to making and keeping wealth in the long-run.
In keeping up with tradition, we are going to introduce a new indicator in this weekend's commentary. It is essentially a monetary indicator - an indicator which seeks to gauge the amount of speculative activity within the U.S. domestic economy. We have labeled this the "MarketThoughts Excess M" indicator (the "MEM indicator"). Basically, it works like this: Whenever our MEM indicator declines below the zero line, there is a lack of "excess cash" in the domestic economy, and vice-versa. The "lack of excess cash" indicates that the turnover of money is high (also known as velocity) - indicating that investors are "risk seeking" as opposed to being risk adverse. This is important - as excess speculation in an economy makes it more prone to a slowdown or a recession, especially given that the bull cycles in commodities, real estate, and the stock market are now getting very mature.
Questions: What is velocity, and why do we use the MEM indicator as a proxy for velocity? How is this MEM indicator calculated?
Although most stock market investors would remember Dr. Irving Fisher for his "Stock prices have reached what looks like a permanently high plateau" quote just days before the 1929 crash and the subsequent Great Depression, it is important to note that he was also one of the most influential economists of the 20th century. He was a pioneer of what is today known as the Fisher Equation: M x V = P x T, or the Quantity of Money Theory, where:
M = money supply
V = velocity of money
P = general price level
T = volume of transactions of goods and services
Readers can read more about the Quantity Theory of Money at this Investopedia link. For our purposes, it is only important to keep note that as the money supply decreases, it takes a higher turnover rate (velocity) of money to maintain the current activity in the domestic economy. Just as with our overbought/oversold indicators, while a rising velocity indicator only tells us that investors and speculators are more risk-seeking, a velocity indicator that is on the high end of its range tells us that the market is on a dangerous footing. A velocity reading that is on the low-end of its range tells us that a boom is inevitable. Such was the case in late 2002 - just before the beginning of this cyclical bull market.
The velocity of money is traditionally calculated using this question: V = GDP / money supply. Unfortunately, preliminary GDP numbers are usually not avaliable until a month after the quarter is over - which pretty much renders this equation useless from our perspective (that of the investor or speculator). Somehow, we need to find an indicator that will give us an idea of the current velocity reading, and here is where our MEM indicator comes into play. Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages). The rationale is two-fold:
The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve. One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base. By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.
The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity). On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking. If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing.
Such is the case we have today. Following is a weekly chart showing the MEM (MarketThoughts Excess M) indicator vs. the St. Louis Adjusted Monetary Base vs. the Dow Industrials from February 1985 to the present:
The drop in velocity during the period from 1990 to 1994 was a huge precursor to the late 1990s bull market. This was further extended with the yen carry trade, when the Bank of Japan actually helped "subsidized" the boom in the U.S. stock markets from 1995 to 1998. Once the yen carry trade ended, we had the Russian Crisis, and LTCM, etc - until the final blow off just subsequent to the St. Louis Adjusted Monetary Base started exploding in late 1999. As one can see, our MEM indicator is currently negative and has been trending downward for some time. This means velocity has been increasing - and combined with a tightening Fed (see green line) and a tightening Bank of Japan (the Japanese monetary base is now hugging the flat line), I believe the markets (especially the commodity markets and real estate) are sitting on the edge right here. We will continue to do work on our velocity indicator going forward, but for now, our MEM indicator will suffice - as the indicator has done a pretty good in gauging the velocity of money in the past.
Of course, similar to the story of our MarketThoughts Global Diffusion Index, this does mean that the markets will fall tomorrow. What it does mean, however, is that until the Fed and the Bank of Japan "play loose" with the monetary base again, any further rallies in the commodity, real estate, and the stock markets will be extremely limited. On the contrary, the downside is potentially huge - even though the market is currently very oversold.