Global Liquidity Warning

By: Henry To | Tue, Dec 6, 2005
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Below is an extract from a "subscriber's only" commentary originally posted at on 4th December 2005.

Dear Subscribers,

New Book Review: Following the success of his first foray into the financial markets with a biography of Warren Buffett, Roger Lowenstein strikes once again in 2000 with the publication of his second book on the financial markets entitled "When Genius Failed: The Rise and Fall of Long-Term Capital Management." Even though I have recommended this book on and "on-and-off basis," this is the first time I have done an "official review" for this book.

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. For now, we are still completely neutral and in cash. With the exception of the Dow Industrials, the Dow Utilities, and the Philadelphia Semiconductor Index, virtually all major market indices (including the Russell 2000 and the S&P 600) made new cyclical bull market highs over the last couple of weeks. Like I mentioned in last weekend's commentary and in our commentaries over the last several weeks, I believe that the Dow Industrials will make a new cyclical bull market high and once it does (topping out 11,000 in the process), the "breakout" will be accompanied by the popular media declaring a new bull market and will subsequently result in many retail investors being pulled back into the stock market - thus completing the last phase of this cyclical bull market. That is, I believe many of these "new investors" will be sorely disappointed going forward.

In last weekend's commentary, I discussed my long-term views of the stock market, and concluded by taking a bearish view as we head into 2006. Among other things, I discussed current valuations relative to its historical range (and for the most part, discredited the bulls' argument against using the P/E ratio has a yardstick for current stock market valuation), the continuing decline in global liquidity, and the recovery of bullish sentiment in recent weeks - which, from a contrarian standpoint, is bearish for the stock market. I argued that while the stock market is overbought in the short-run, the four-week and the ten-week moving averages of our sentiment indicators are still calling for more upside in the next couple of months. So far, I am still sticking to this timeline. Recent deteriorations in global liquidity and the continuing increase in the overbought conditions of our sentiment indicators are telling us that we are getting close to a significant top in the stock market.

I would first like to begin this commentary by reiterating our stance on the deterioration of global liquidity. Ever since the underperformance of the Philadelphia Bank Index over six months ago, we have been warning of an impending liquidity squeeze. This has been further compounded with our work on the growth of the amount of foreign assets held at the Federal Reserve banks - as first discussed in our May 1st commentary entitled: "The U.S. Dollar is Going Up." Of course, deteriorating global liquidity may not be much of a concern if investors and consumers around the world have been more cautious with their money, but that has not been the case - as our MarketThoughts "Excess M" (MEM) Indicator had first tried to take into account in our October 23rd commentary. As a compliment to our commentaries, I had also highly recommended reading John Mauldin's recent "Outside the Box" article on "Deteriorating Global Liquidity" (original author: Mr. Niels Jensen, President of Absolute Return Partners).

Speaking of our MEM indicator, it has been more than three weeks since our last update of this indicator. Readers who would like a review of our MEM indicator should go back and read our October 23rd commentary, but in short, 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). Such an indicator is used to measure "financial velocity", or in other words, the amount of speculation that exits in our financial markets today. Since more than three weeks ago - U.S. liquidity - as measured by our MEM indicator, has continued to turn for the worst. This does not bode well for the stock and commodity markets going forward:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-3 (February 1985 to Present) - 1) Speculators continues to be aggressive in the face of the Fed reining in the monetary base.  Our MEM indicator stretched further to the downside in the last two weeks from negative 3.44% to negative 4.06% - the lowest since Jan 2002.  This does not bode well for the markets going forward. 2) Markets did well during the 1995 to 1998 - despite a decline in the monetary base and immense speculation - primarily because of the Yen carry trade!  But now, the BoJ is tightening as well...

As one can see, the fact that our MEM indicator continues to trend down, coupled with the fact that M-3 continues to increase while the Monetary Base is increasing, is especially bearish for the stock market and commodity markets going forward. For readers who would like a review of the latter, please read our November 10th commentary entitled: "Seeking Guides for the Financial Markets." Per the guide post (the quadrant signaling four possible scenarios of the direction of the monetary base and M-3) in that commentary, we are now definitely getting deeper in the bottom, left-hand quadrant. In brief, this means that speculators continue to be more risk seeking in the face of a continuing decline in global liquidity. Finally, as mentioned in the above chart, our MEM indicator has not been this bearish since January 2002 - just four months prior to the huge May to July 2002 decline.

A discussion of declining global and U.S. liquidity would not be complete without an update of the chart showing the relative strength of the Philadelphia Bank Index vs. the S&P 500. As I mentioned last week, the relative strength of the Bank Index was on the verge of breaking through its huge resistance line - a resistance line that was initially pierced (downwards) approximately nine months ago and that stretches back to early 2003. The action of the Bank Index over the last week, however, has been significantly bearish, as relative strength of the Bank Index vs. the S&P 500 is once again turning down after testing the resistance line:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1)  The last time the relative strength of the Bank Index broke down in a significant way was during the July 1998 period - and we all know what happened afterwards. 2) The decline in relative strength of the Bank Index after the LTCM and Russia crisis and during 1999 suggested tougher times ahead for the U.S. stock market -- and in retrospect, it was cold-bloodedly right. 3)Relative strength of the Bank Index finally broke through support convincingly approximately nine months ago and and has stayed down since - with the exception of a back-kiss off the same line 31 weeks ago.  Note that relative strength of the Bank Index has recently been trying to push through major resistance, but has so far, failed to do so.  In fact, the significant decline of the Bank Index relative to the S&P 500 last week most probably signaled a new downward trend in relative strength.  Bottom line: Global liquidity continues to deteroriate.

Please note that the last time this resistance line was tested was more than six months ago - and my guess is that the latest test will be a failure once again. In fact, the dismal performance of the Bank Index relative to the S&P 500 last week (without any significant news from the financial sector) was telling. The fact that the Federal Reserve should continue to tighten on December 13th and January 31st should ensure that the Bank Index will continue to underperform going forward. Coming off an era of extremely generous liquidity, there is little chance that the stock market or the commodity markets will hold at current levels. In fact, this author would not be surprised if we see some kind of "financial accident" in either an emerging market country or in one of the companies of the S&P 500 - such as the bankruptcy of GM or Ford, for example.


Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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