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Henry To

Henry To

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is…

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Where is Stock Market Liquidity Now Heading?

Dear Subscribers,

In the stock market - just as in life - the quest to keep up with everyone else is not only imperative for the quest for "alpha," but is also a necessity for survival. Since the beginning of this century, we have witnessed an explosion of the influence of the financial sector - not just in the value of all financial companies but also in the number of instruments and financial asset classes that can now be traded with relative ease, such as REITs, emerging markets, and more importantly, many new kinds of derivative instruments. This continuing trend of the increasing influence of the financial sector did not come about merely because of the huge amount of liquidity that was dumped into the markets in 2001 and 2002 (and which the central banks have still yet mopped up) - but mostly because of three things: financial liberalization, increased computing power, and the continuing quest to hedge as many types of risks as possible (and on the flip side, to expand the "efficient frontiers" of hedge funds and high net worth individuals alike).

One manifestation is the explosion of the currency, interest rate, and credit default swaps markets. Following is a semi-annual chart showing the notional amount (in US$ billions) outstanding in the currency & interest rate swaps and the credit default swaps markets from 1H 1997 to 2H 2006, courtesy of the ISDA:

Total Currency & Interest Rates Swaps and CDS Outstanding (US$billions) (1H 1997 to 2H 2006)

Over the last ten years, the currency and interest rates swaps market has grown nearly ten times - increasing from a total notional amount outstanding of $28.7 trillion to $285.7 trillion. At the end of the 20th century, the credit default swaps (CDS) market did not even exist. From a total notional amount outstanding of $630 billion in 1H 2001, the CDS market has grown to a $34.4 trillion market in just six years. Given the continuing increase in cheap computing power and cheap bandwidth (see our June 24, 2007 commentary "The Times They Are a-Changin" for our views on how this will impact our lives in the next decade), and given the continuing emphasis on more financial education in our colleges today, the trend of an ever-expanding financial sector should continue to grow for the foreseeable future.

For subscribers who prefer to not spend their Sundays reading technical papers on the CDS or the CLO markets, I would - again - highly recommend reading Robert Shiller's book on hedging risks in the 21st century, entitled "The New Financial Order." Another excellent book on modern finance that this author is currently reading is the just-released "Capital Ideas Evolving" by Peter Bernstein. Both of these books are very well written and are easy to understand. For those who do not have a background on modern financial/portfolio theory, I would highly recommend reading an earlier book (published in 1992) written by Peter Bernstein on this subject, entitled "Capital Ideas." Incidentally, we have just published a book review on "Capital Ideas" in our "Favorite Books" section of our website.

As I have mentioned before - primarily because of the continuing exponential pace of change we are witnessing in both the domestic and international stock markets - what you see on this website in a few years will most likely not resemble the content that you are seeing here today. Sure, the Dow indices and the sentiment charts will still be here, but we will most likely be more actively covering the international markets as well as the derivative (and even virtual) markets. Because of this, we are currently evaluating many global data vendors in order for us to improve our service going forward. However, the data and software does not come cheap - and thus we would like to get as many new subscribers as possible over the next couple of months. Subscribers and readers, please continue to support us by letting your friends know about our site and asking them to subscribe if they are interested! Rex and I will fully appreciate your help.

As an aside: For a "dislocation" technology in the restaurant industry, look no further than the Microsoft "Surface" technology - which is simply an amazing piece of technology. At first glance, kids will simply think of this as a cool technology to view photos or transfer videos, but give it a couple of years and many restaurants will start utilizing this technology as part of their food/drink ordering and clean-up system. Besides having the ability to order food or drinks, the "Surface" will know what you are drinking and will ask you if you need a refill when your cup is half-empty. Once all your plates are empty or nearly empty, the "Surface" will also alert the busboy so he can come and remove your dishes. At the same time, you will be able to start ordering desserts as well, or of course, pay for your meal (either through your credit card or through Paypal). In five years, the number of waiters needed in the restaurant industry will be halved, and 15% tips will no longer be needed (assuming a reasonable 40% decline in cost each year, these US$10,000 machines/surfaces will only cost US$750 by the end of 2012). What outsourcing or off-shoring cannot do (i.e. displace workers whose jobs tend to be localized), technology will.

Let us know begin our commentary by providing update on our three most recent signals in our DJIA Timing System

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As of Sunday evening on July 15th, we are still neutral in our DJIA Timing System (subscribers who want to go back and review our historical signals can do so at the following link). While it would have worked out well if we had continue to hold our long position since May 8th, we decided to exit our position at that time since there were many signs - including most of our valuation, sentiment, and liquidity indicators - that the rally was getting tired. We continue to stand by this position, as - despite the stock market rally over the last two weeks - there continues to be signs of declining liquidity. This includes the failure of the NYSE A/D line to surpass its all-time high last Friday, as well as the continuing signs of stress being witnessed in the junk bond and the CMBS market (besides the continuing mess in the subprime market), as well as the huge reliance on the Yen carry trade to fund a broad range of investments around the world.

In our last weekend commentary on July 1st, I stated: "However, we currently do not plan to go short in our DJIA Timing System - not even in the midst of the latest Bear Stearns hedge fund crisis - at least not until we see a brief but weak rally in the stock market. We also would prefer to see a Dow Industrials reading in the 13,800 to 14,200 area before shorting, but this point, we cannot be "greedy," so this author may actually end up on initiating a 50% short position in our DJIA Timing System should we see an unsuccessful retest of the previous all-time high, assuming that the rest of the market (and the Dow Transports) remains weak. Should we decide to go short, we will inform our subscribers by emailing you a real-time "special alert." While equities still remain relatively cheap (as measured via valuations since 1994), readers should keep in mind that on a relative basis (especially in relation to U.S. bonds), U.S equities are still near its most expensive level since May 2006, despite the weakness of the stock market over the last few weeks. Combined with the liquidity headwinds that we have previously discussed, stocks are definitely not too attractive at this point, especially as the Yen carry trade is now very stretched by any measure and as the world's major central banks are still in a tightening phase. Because of these reasons, we have chosen to get out of our 100% long position in our DJIA Timing System on May 8th."

Based on the above statement, we are now getting close to initiating a 50% short position in our DJIA Timing System. Since the subject of this commentary is about U.S. stock market liquidity, let us now start with that. Folks who have continued to monitor central bank developments (not just the Federal Reserve, the ECB, or the Bank of Japan, but also the People's Bank of China, the Bank of England, the Reserve Bank of Australia, and the Bank of Korea as well) will know that the central banks of the world have continued to tighten "primary liquidity" over the last few weeks. As late as last Friday, the People's Bank of China took the unprecedented step of selling US$13 billion worth of 3-year bills to four commercial banks (these banks are obliged to buy the bills) at a yield of 3.6% - with the intent of draining more liquidity from its financial system. Another 27 basis point rate hike by China over the next month or so is now inevitable. Even the Bank of Japan is expected to raise rates at the conclusion of its next policy meeting on August 23rd.

Within the United States, the continuing decline of "primary liquidity" can be witnessed in the continuing decline in the St. Louis Adjusted Monetary Base, which we had last mentioned in our June 3rd commentary, as part of our update on our MarketThoughts "Excess M" (MEM) indicator. As I mentioned in that commentary, I still believe it is a relevant indicator, even in today's globalized world of financial flows. Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: 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 for using this is two-fold:

  1. 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 ultimately, fighting the Fed usually ends in tears more often than not.

  2. 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. Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3. Instead, M-3 is directly affected by the ability and willingness of commercials banks, hedge funds, private equity funds, and foreign central banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has stopped publishing M-3 statistics, this author has revised our MEM indicator accordingly. Instead of using M-3, we are now using a monetary indicator that most closely resembles the usefulness of M-3 - that is, a measurement that tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy. We went back and found one measurement that is very close - that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 that the Fed is still publishing on a weekly basis). That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator. Following is a weekly chart showing our "new: MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-2 outside of M-1 plus Institutional Money Funds (April 1985 to Present) - Speculators have gotten much more aggressive despite the dismal growth in *primary liquidity* and a tightening ECB, Bank of England, and Bank of Japan. Investors should continue to tread carefully, especially in areas where the Japanese carry trade has been a very popular trade. Moreover, this indicator of speculation vs. liquidity in the markets is now at its most dire signal since January 2002. 4) Markets did well during 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...

Since our June 3rd discussion revolving around our MEM indicator, it has continued to decline - signaling a further deterioration of prime liquidity vs. "secondary" liquidity. That is, while foreign investment banks, commercial banks, hedge funds, and private equity funds are still busy creating liquidity, the Federal Reserve itself has continued to remove liquidity from the global financial system. This is evident by the dismal 1.6% growth in the St. Louis Adjusted Monetary base over the last 12 months. At this point (similar to the 1995 to 1998 period), the world is being "held ransom" by both the Bank of Japan, the Japanese Ministry of Finance, and the Japanese retail investor, as these parties are now playing the role of "liquidity provider of last resort" in the form of the Yen carry trade. However, since Japan runs a current account surplus, it is to be noted that Japan is thus not a natural exporter of their currency (unlike the U.S.). Moreover, the Yen carry trade - by any measure - is now way, way, overstretched. That is - if this continues - at some point, there would be a liquidity squeeze in Yen - not unsimilar to what occurred during the Fall of 1998 (when the Yen appreciated over 10% in an hour).

The Yen carry trade, however, can go on indefinitely until one of the two following occurs: 1) Both Japanese private pension funds and Japanese retail investors have exhausted their savings, or 2) For some reason, the Japanese repatriate their savings, by selling foreign assets and reinvesting their savings into domestic savings accounts or domestic assets instead.

At this point, the urge to invest in foreign assets is still strong among the Japanese, despite the continuing unfolding of the subprime mess here in the US (it is now known that many buyers of these CDOs were actually European and Asian institutional investors who bought the paper simply because they were triple A rated). However, as I mentioned in our latest mid-week commentary, the subprime mess is still not close to being over, and the jury is still out on whether it is going to morph into some kind of "systemic event" in the future. What is evident - at this point - is that investors' risk appetite is now slowly fading, as evident by the recent increase in spreads in both the junk bond and the CMBS market.

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