Tags

Since the end of February when the S&P 500 closed at 735.09, the index has been pushing strongly ahead, closing on Friday, May 8, at 929.23 — an increase of 26.4%. We suggest that the key driving force behind this strong bounce is a massive increase in liquidity. What is it all about, and how do changes in liquidity drive the stock market?

In a market economy, a major service that money provides is that of the medium of exchange. Producers exchange their goods for money and then exchange money for other goods.

The increase of production of goods and services results in a greater demand for the services of the medium of exchange (the service that money provides). Conversely, as economic activity slows down, the demand for the services of money follows suit.

The demand for the services of the medium of exchange is also affected by changes in prices. An increase in the prices of goods and services leads to an increase in the demand for the medium of exchange. People now demand more money to facilitate more expensive goods and services.

A fall in the prices of goods and services results in a decline in the demand for the medium of exchange.

Now, take the example where an increase in the supply of money for a given state of economic activity has taken place. Since there wasn't any change in the demand for the services of the medium of exchange, this means that people now have a surplus of money or an increase in monetary liquidity.

Obviously, no individual wants to hold more money than is required. An individual can get rid of surplus cash by exchanging the money for goods.

All the individuals as a group, however, cannot get rid of the surplus of money just like that. They can only shift money from one individual to another individual.

The mechanism that generates the elimination of the surplus of cash is the increase in the prices of goods. Once individuals start to employ the surplus cash in acquiring goods, this pushes prices higher.

As a result, the demand for the services of money increases. All this in turn works towards the elimination of the monetary surplus.

Once money enters a particular market, more money is now paid for a product in that market. Or we can say that the price of a good in this market has now gone up. (Remember a price is the number of dollars per unit of something.)

Note that what has triggered increases in the prices of goods in various markets is the increase in the monetary surplus or monetary liquidity in response to the increase in the money supply.

While increases in the money supply result in a monetary surplus, a fall in the money supply for a given level of economic activity leads to a monetary deficit. Individuals still demand the same amount of the services of the medium of exchange. To accommodate this, they will start selling goods, thus pushing their prices down.

At the lower prices the demand for the services of the medium of exchange declines and this in turn works toward the elimination of the monetary deficit.

A change in liquidity or the monetary surplus can also take place in response to changes in economic activity and changes in prices. For instance, an increase in liquidity can emerge for a given stock of money and a decline in economic activity.

A fall in economic activity means that fewer goods are now produced. This means that fewer goods are going to be exchanged, implying a decline in the demand for the services of money — the services of the medium of exchange.

Once, however, a surplus of money emerges, it produces exactly the same outcome with respect to the prices of goods and services as the increase in money supply does, i.e., it pushes prices higher. An increase in prices in turn works towards the elimination of the surplus of money — the elimination of monetary liquidity.

Conversely an increase in economic activity while the stock of money stays unchanged produces a monetary deficit. This in turn sets in motion the selling of goods thereby depressing their prices. The fall in prices in turn works towards the elimination of the monetary deficit.

There is a time lag between changes in liquidity, i.e., a monetary surplus and changes in asset prices, such as the prices of stocks.

For instance, there could be a long time lag between the peak in liquidity and the peak in the stock market. The effect of previously rising liquidity could continue to dominate the effect of currently falling liquidity for some period of time. Hence the peak in the stock market emerges once the declining liquidity is starting to dominate the scene.

(The reason for the lag is because when money is injected it doesn't affect all the individuals and hence all the markets instantly. There are earlier and later recipients of money.)

Exploring how changes in liquidity had historically been driving the stock market.

For instance, the yearly rate of growth of our monetary measure AMS stood at 4.1% in March 1974 and 4.5% in May the following year. Despite the relative stable money-supply rate of growth, the yearly rate of growth of monetary surplus had a large increase from negative 7.7% in March 1974 to a positive figure of 7.6% in May 1975.

(Note that the yearly rate of growth of the consumer price index (CPI) eased from 10.1% in March 1974 to 9.3% in May 1975. The yearly rate of growth of industrial production fell from 1.7% in March 1974 to negative 12.4% in May 1975.)

In response to the increase in the monetary surplus, the S&P 500 shot up from 68.6 in December 1974 to 95.2 by June 1975 — an increase of 38.8%.

Now, the yearly rate of growth of liquidity topped in November 1927 at 10.2%. After a time lag of 22 months, the S&P 500 responded by peaking in August 1929 at 31.71.

In 1987 the time lag between a peak in liquidity and a peak in the stock market was much shorter. The yearly rate of growth of liquidity topped in January 1987 at 15.1%. The S&P responded to this by peaking eight months later at 329.9 in September of that year.

According to the historical data, the yearly rate of growth of liquidity bottomed at negative 16.6% in May 1929. Yet it took a long time before the S&P 500 responded to this. It took over three years after the bottom in liquidity was reached before the S&P started to recover. The stock-price index bottomed in June 1932 at 4.43.

The time lag between the bottom in liquidity and the bottom in the stock market has been shorter in more recent history. Thus the yearly rate of growth of liquidity had bottomed at negative 5.7% in September 2000. It took twenty-five months before the S&P 500 bottomed at 815.28 by September 2002.

What is the current state of US liquidity, and where is the S&P 500 heading?

The current bear market that started in October 2007 was preceded by a peak in the liquidity rate of growth in June 2003 — a time lag of over four years. The yearly rate of growth of liquidity stood at 7% in June 2003. The S&P 500 climbed to 1,549.38 by the end of October 2007.

Observe that at the end of February 2009, the S&P 500 closed at 735.1 — a fall of 52.6% from the peak in October 2007. The yearly rate of growth of monetary liquidity hit bottom in January 2008 at negative 6.1%. By the end of April, the yearly rate of growth of liquidity stood at positive figure of 24.9%.

On the face of this, and on account of aggressive monetary pumping by the Fed, one is tempted to argue that the time lag from the bottom of liquidity to the bottom of the stock market may have significantly shortened and is about one year. In short, the stock market is already in the bull phase. We suggest that a shaky state of the pool of real savings might pose a threat to the stock market notwithstanding the massive monetary pumping by the Fed. Here is why.

We have seen that in some cases, such as the Great Depression of the 1930s, the time lag between the bottom in the growth momentum of liquidity and the beginning of a new bull market can be extremely long. An important factor that prolongs the lag is that an increase in liquidity on account of a collapse in the economy is not a great incentive to put money into stocks.

Despite massive increases in liquidity, as we had during the 1930s, the risk-adjusted return for being in stocks wasn't that attractive relative to some other asset classes, such as treasuries or just keeping money in cash or in short-term money-market instruments.

An increase in liquidity rather than entering the stock market in this case supports other markets. Note that by June 1931 the S&P 500 stood at 14.8, against 21.45 in December 1929 — a fall of 31%. This fall took place despite an increase in the rate of growth of liquidity from 4.7% in December 1929 to 21% by June 1931.

In contrast, the increase in liquidity was supporting Treasuries. The yield on the 10-year Treasury bond was in a gentle downtrend. The yield eased from 3.4% in December 1929 to around 3% by June 1931.

We suggest that, at present, if the pool of real savings is still in trouble, then we are unlikely to have a sustained economic revival. If anything, all the rescue packages and all the massive pumping by the Fed has made things much worse as far as the underlying economic bottom line is concerned.

This in turn means that, despite lofty liquidity, bad economic fundamentals might force investors to direct their money towards other assets, such as Treasuries — and gold. If our assessment regarding economic fundamentals is correct, then the underlying downtrend in long-term Treasuries is likely to stay in force while the price of gold is likely to easily surpass the $1,000 mark.

Conclusion