Sense on Cents

Is the economy providing subtle but solid signs of health to lead our equity markets to further gains? Do investors see signs amidst market flows compelling them to put money to work despite mixed economic signals? Is there a combination of both reasons driving the market? Let’s dig deeper and navigate.

The DJIA and S&P 500 have rallied 30+% from the March lows. Credit spreads within the bond market have also performed tremendously well from that time period. On a year to date basis, the DJIA and S&P 500 are now unchanged to slightly positive.

Were the markets being overly pessimistic in March? Were they too fearful of the great unknown? Are they overly optimistic at this point? I believe the markets are being driven much more by a bullish technical correction based upon an increased liquidity cushion than any sort of real fundamental economic factors.

From my perspective, the Fed and Treasury have created nothing short of a flood of liquidity throughout our financial system and economy. While the economic activity is anything but robust, this money is in the system. Banks are not aggressively looking to lend and will not cut interest rates or credit standards. The shadow banking system (securitization process) remains stagnant.

Thus, where does the money/liquidity go? Much like pools of water after a torrential rainstorm, the pools of liquidity in our system are looking to penetrate any available crack and crevice.

The Fed and banking system are very subtly, but effectively, compelling people to put their money to work in the market. How so? By leaving the Fed Funds rate, and other very short term rates, at such extremely low levels and professing they will stay at those low levels for the foreseeable future.

Thus, much like that pool of water looking for a crack in a foundation and finding it, the pool of liquidity in our economy is being pushed into the market rather than remaining stagnant in CDs, money markets and the like.

Does the market represent good value at current levels? Not by any reasonable measures. But this market is not about value or fundamentals at this juncture. This market is purely a technically driven market in which the pool of liquidity is chasing stocks higher.

What sectors are leading the market? The oil, gas, energy, and other assorted commodities for one. Financials, primarily the large money center banks, for another. What’s driving these sectors?

The former group is pricing in expectant inflation sooner than otherwise predicted, as the WSJ reports, Oil Rises On Inflation Trade. China is aggressively purchasing a wide swath of commodities in large volume. The financials are benefitting from an extremely cheap source of funding, that is, deposits and Fed Funds of 0-1%.

What remains the greatest risk to this flood of liquidity pouring into the equity markets? The technical flows so far outpace any sort of reasonable fundamental analysis increasing the risk that an equity bubble develops. What would cause that bubble to pop? Higher interest rates. What would cause rates to increase even further? Inflation and ongoing enormous fiscal deficits.

Rising equity markets may provide a degree of comfort at this juncture. I think it is critically important, though, to understand what is driving the market and what is further down the road on our economic landscape.

LD