Is the Stock Market Rebound From the Flash Crash Sustainable?, The Answer Lies in Liquidity
Stock-Markets / Stock Markets 2010 May 13, 2010 - 04:30 PM GMTBy: Q1_Publishing
The only thing that matters in this market is liquidity.
As last Thursday’s market sell-off and this week’s rebound have proven, the only real factor driving the markets higher is liquidity.
That’s why all the recent action directly or indirectly related to the Greek bailout, the European Central Bank (ECB) monetizing more debt, the ongoing bailouts of Fannie Mae and Freddie Mac, and deep deficits of Western governments at all levels, simply further cement the most important trend of the next decade.
It’s a trend that will make fortunes for some and cost others a lot. Here’s how to ensure you’re on the right side of it all.
The Set Up
The western world is drowning in debt. Western governments, corporations, and consumers (as a whole) are all deeply indebted.
Credit is not expanding. Consumers and businesses are actually paying down debts.
The thing is though, when credit contracts, liquidity dries up. And less liquidity means lenders have to be more careful with the money they have. So they are less likely to make loans to bankrupt governments (i.e. Greece, California, Illinois, etc.) and make riskier loans to small businesses and consumers.
The signs are everywhere. Whether you’re a corporation rolling over debt, trying to get a small business loan, or a consumer just looking to get a loan other than a mortgage - which 90% of all newly issued ones now carry a government guarantee – loans are tougher to get.
Liquidity is drying up and it has the governments scared to death.
After all, less liquidity means bad things are going to happen.
That’s why we’re keeping a close eye on the world’s ultimate liquidity measure - the TED Spread - to see the market’s next move.
The Ultimate Liquidity Indicator
The TED spread is the difference between the rate on the “risk-free” 3-Month U.S. Treasury Bills and the interbank lending rate.
The spread increases when liquidity dries up and banks consider lending to each other to be risky. It rises because banks buy T-Bills and push down rates on them and demand higher rates for interbank loans.
The spread falls when banks perceive less risk of lending to each other and they want to eke out a greater return by lending to each other rather than buying “risk-free” T-bills.
In a market where liquidity means everything, the TED spread is the key indicator of where the markets are headed next.
The chart below shows the TED Spread over the last five years:
It’s easy to see a correlation between liquidity (as tracked by the TED spread) and stocks, gold, and commodities.
Over the long term, the relationship between the TED spread and stocks is even more apparent (view long-term TED spread vs. stocks chart here).
TED spread down, liquidity and stocks up. TED spread up, liquidity and stocks down.
It really is that simple.
That’s why it was no surprise to see the rebound this week. Last Thursday’s sell-off was not a sign of a bigger panic. After all, the market self-corrected within a matter of minutes. The liquidity was there, although to a lesser extent, but it was there. As a result, TED spread barely jumped.
Now a week later, liquidity has increased substantially, the TED spread has started falling back down, and stocks are back on the rise.
It’s the Liquidity, Stupid
So that’s where we’re at right now.
The ECB has proven its resolve to keep the liquidity spigot open despite the short- and long-term costs – political or otherwise.
Injecting billions of dollars of liquidity into the financial system by buying Greek debt at above-market prices, handing Greece cash, and by taking an untold sum of European governments’ outstanding debt (a.k.a. monetizing) off the hands of banks, has provided a short-term jolt of liquidity.
And in a market driven by liquidity, it naturally reacted positively.
The thing is though, more and more investors are realizing what’s going on. Problems, a.k.a. “threats to the financial system,” come up and they’re just shifted up the chain.
When the banks had problems, the Federal Reserve and the U.S. government took them over. When Greece had problems, the entire European Union took them on.
There’s a clear trend forming and there’s no reason to expect a different solution with the next crisis. Whether it’s commercial real estate, state government budgets, or the next European welfare state to collapse under its own entitlements, the problems will just be passed the next stop up the chain.
But more and more investors have figured out there are only so many levels to shift problems up to. Eventually something has to give. And right now we expect that to be the value of currencies. And over time a steady devaluation of currencies is going to mean two things are going much, much higher – interest rates and commodities.
So for now, with liquidity on the rise, it’s still too early to bet against this rally just yet.
That’s why there’s still time to get in position for higher interest rates – you will not regret it. And when it comes to commodities, we’ll look at where to find the biggest gains in the coming historic run for gold (hint: it goes against everything that’s happening in precious metals stocks right now) in the next Prosperity Dispatch (sign up here – it’s free) and the current corrections in oil and agriculture commodities will be viewed, in time, as opportunities.
Good investing,
Andrew Mickey
Chief Investment Strategist, Q1 Publishing
Disclosure: Author currently holds a long position in Silvercorp Metals (SVM), physical silver, and no position in any of the other companies mentioned.
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