In the big picture, a novel indicator that reflects factors that cause longer term effects on the price of equities is Lee Adler’s “liquidity indicator.” Its moves are not caused by economic conditions but by the money flow between financial giants - governments and central banks. Reviewing the components of his liquidity indicator this week, Lee concludes that we have enough liquidity for one bull market – stocks or bonds – not both.
Below is a long excerpt from Lee’s recent analysis for his subscribers. Lee is a contributor to our Market Shadows newsletter, and we featured his “Liquidity Indicator” in this week edition.
Courtesy of Lee Adler of the Wall Street Examiner
The composite liquidity indicator had a tiny downtick last week. The indicator has remained essentially flat for most of July, but is still firmly entrenched in a strong up- trend.
Composite Liquidity Indicator
The Fed’s buying of MBS (mortgage backed securities) and the slight tilt of Operation Twist toward more purchases from Primary Dealers than sales to them, will remain a bullish influence at least until year end. Large bank trading account patterns are still bullish while bank net Treasury pur- chases are back to a neutral pattern. Net bank inflows are in a slightly bullish inter- mediate trend, while reserve deposits at the Fed remain in a neutral pattern. Foreign central bank purchase patterns have im- proved from bearish to neutral.
Taken as a whole, that should be enough to keep Treasuries at very low yields and to continue to give stocks a boost. It’s too soon to tell if there’s a sentiment shift un- der way away from Treasuries. All else be- ing equal, that would work in favor of strengthening equities, but if yields head to new lows, stocks should roll over. Liquidity, while bullish, still seems insufficient to sup- port bull moves in both investment classes.
Macroliquidity Component Indicators
The Fed continues to pump cash into Primary Dealer trading accounts via its MBS purchases. The trend of this indicator remains bullish and will continue to be bullish under the extension of the MBS purchase program through the end of 2012.
(This indicator has the heaviest weighting in the composite. The correlations have held remarkably well since I began tracking this in 2002. It is a proprietary indicator composed of the cumulative value of operations which the Fed conducts directly with Primary Dealers.)
Fed Cash To Primary Dealers
An important measure of market liquidity is US banking system net deposit flows. Banking system net money flows showed an outflow of $13 billion in the week ended July 16, pulling back from a nominal new high, while the 4 week moving average up- ticked slightly from being flat. None of the- se changes seem material yet. The indicator has barely emerged from the range it has been in since March. Stocks have gone no- where during this time. A downturn from this point would be a bearish indication. If the indicator breaks out to a new high, the trend would be bullish.
Net Change In Money Holdings Vs. Stock and Bond Prices
Bank Treasury purchases are another key measure of market liquidity. Commercial banks’ Treasury and Agency (GSE) holdings dropped by $2.5 billion in the week ended July 18. That followed a jump of $12.5 bil- lion the previous week, and a record surge of $19.8 billion in the week ended June 27.
The sudden wild volatility has made this indicator a wild card, but due to the selling in the most recent week, I’d call the trend neutral for now.
For a comprehensive analysis of Lee’s proprietary Liquidity Indicator, and weekly updates of how the components are behaving, click this link to try WSE’s Professional Edition risk free for 30 days!