Since 2004 the Federal Reserve has pursued a tight money policy. The consistent hikes in the Fed Funds interest rate have been too numerous to count. At the same time the interest rate was rising the broad money supply (as measured by 3-year MZM annualized growth) was dropping like a rock when measured from a rate of change basis. The results of this policy weren't altogether unpredictable, especially as this tightening bias bottomed out with the recent bottom in the 8-year cycle. Gold and silver fell hard during the 8-year bottom and in recognition of this monetary tightness, along with other major commodities including oil. Now even the "natural" rate of interest is dropping and can be seen in the decline in the 10-year Treasury yield. This drop has produced, temporarily, an inverted yield curve as if to accentuate the fact the Fed went too far in its tightening campaign.
The ball is now in the Fed's court and its next move must be to lower interest rates. "Toeing the line" as the financial press likes to describe it, isn't enough. It was good that the Fed at least had the sense to not raise rates after the most recent FOMC meeting but now it must commit itself to a policy of loosening and of increasing monetary liquidity. When The Fed commits itself to loose money the stock market will respond favorably and we'll witness that pent up energy of the past year being released in the form of a vigorous and sustained stock market rally in both the NYSE and the NASDAQ.
The market really does want to break out and runaway on the upside but has been prevented these many long months by the stubborn actions (or inaction) of the Fed. The big question confronting the financial world today is "Can the U.S. economy bear any further increase in the interest rate, i.e., any further monetary tightness?" The simple answer to that question is "no!" The second question that follows the first is, "Can a sustainable and meaningful bull market in stocks begin without first an increase in money supply and lowering of interest rates?" Again the answer is "no." The final question, which we'll ask of the market itself, is, "Will the Fed finally come to its senses and begin loosening its monetary policy in a way that will favor the stock market?" The answer, according to the message of the market, is "yes!" Let's examine some of these factors that will have an impact on the direction of stock prices in the coming months.
"Worry about economy weighs on stocks" was one of the headlines this afternoon on the financial news wire last week. Another one was "Pessimism about economy dents stocks." Concerns about U.S. economic growth and the possibility of recession are of paramount concern right now, coming as we are off a low ebb in the business cycle. While a major recession isn't anticipated, there is no denying that monetary liquidity is in dire need of re-fueling right now in order to prevent a further slippage of U.S. economic growth. Money supply is also the propellant that fuels the great engine of economic growth and by extension is a necessary ingredient for a healthy bull market in stocks.
Let's start our review of the liquidity situation by looking at the trend of demand deposits at commercial banks, a statistic provided by the St. Louis Fed (www.stlouisfed.org). The trend for demand deposits has been down since last year and is one reflection of the lack of liquidity that needs to be refreshed following the latest 8-year cycle low.
Next we turn to the consumer credit trend, specifically the rate of change in consumer credit outstanding. If you go back and look at the past 25 years of this trend you'll see that in every case when the 4-year cycle was bottoming, and especially when the 4-year cycle bottomed along with the 8-year cycle, there was a big decline in consumer credit outstanding. This was true of the 8-year cycle lows of 1982, 1990, 1998 and most recently 2006. That's considered bearish for the retail economy for obvious reasons. Moreover, in the years classified as recession years (namely 1991 and 2001) we find the consumer credit trend hitting an extreme low point before trending higher again as the Fed was forced to re-liquify the banking system which in turned encouraged more consumer spending.
It has been stated by some observers that the period of economic recovery following the last recession in 2001 until now has been one of the weakest recoveries in recent U.S. economic history. The rate of change trend in consumer credit certainly supports this assertion as the chart shows a series of lower highs and lower lows being made from the peak of late 2001/early 2002 (when the Fed was forced to open wide the monetary spigot) until the most recent low made earlier this year. This is in contrast to the series of higher highs and higher lows in the consumer credit trend from the period of 1990-1995 following the 8-year cycle bottom of 1990. Those years encompassed what was undoubtedly the most constructive period stock market gains of the last 30 years with the years 1995-1996 being especially bullish.
The bank credit trend, while not bearish, isn't as strong as it could be in support of sustained economic growth and will need to show improvement in the coming weeks and months to add fuel to the anticipated 2007 bull market. Bank credit, like the other monetary indicators mentioned here, tends to contract heading into an 4-year cycle low but typically increases following it.
To show you in numeric terms how much the broad money supply as measured by MZM (Money Zero Maturity) has shrunk since the reliquification of 2001 here is a table showing the percentage change at an annual rate of MZM starting with the year 2001:
As of the second quarter of 2006 the annualized growth rate of MZM is only 2.6%. This is another measure of liquidity that will have to show some drastic improvement in the coming months in order to support the bull market of 2007. Since most of these monetary measures following the basic 4-year cycle and its multiples (e.g., the 8-year and 12-year cycles) it is reasonable to expect that we will see an improvement in monetary liquidity in the next few months ahead.
The last time the 8-year cycle bottomed in September 1998 the overall stock market and economic environment was similar in some respects to what we're experiencing now. It took several weeks following the cycle low September 1, 1998 before the broad market was sufficiently strong enough to break away and begin a new sustained bull market but it did happen in the fourth quarter that year. I expect a similar occurrence this time around with stocks turning up strongly again sometime in October or early November.
Someone has asked, "What about the decennial cycle seventh year which posts negative results [in the stock market]?"
To that I answer that the seventh year of the decade does have a tendency to show weakness during the fourth quarter. But it will do us well to keep in mind that 1987 and 1997 both were actually good years for the market up until October. I'm not necessarily expecting 2007 to be a huge winner as measured from start to finish -- I'm just expecting a bullish environment for the first 2-3 quarters.
The last time the seventh year was really a loser was in 1977 and that year was a downer all the way through mainly because the 12-year cycle was down hard into 1978. This time around the 12-year cycle *peaks* in 2008 -- the exact opposite of '77. Also, keep in mind that in 2007 the market will have a new 8-year cycle upward phase behind it which is another longer-term cycle that will be in the market's favor next year.