Weekly Bear: The One Bloodletting Chart You Need to See This Weekend

Macroliquidity is still trending higher but the trend is flattening as the Fed withdraws money from the banking system and extinguishes it. That means that there is less and less money available to absorb new securities issuance, particularly US Treasuries.

Every April and May, the markets get a break as tax receipts come in and the government pays down debt. This year has seen a particularly big influx of cash into the markets, which I cover in detail in the Wall Street Examiner Treasury market updates. This positive period is now coming to an end. So don’t be lulled into a false sense that the bull is back. This is temporary. The trend of money shrinkage will continue, and that will negatively impact stock prices in the months ahead.

Here’s how the data breaks down….thanks to my “secret weapon,” the Composite Liquidity Indicator. As you’ll recall, it combines four different measures of US systemic liquidity, with the most important being a measure of the cash flowing from the Fed to the Primary Dealers.

What you see here is the liquidity curve flattening, in preparation for a downturn, as the Fed drains blood from the markets:

The overextension of stock prices relative to macro liquidity has begun to correct, but it is still high. Therefore risk remains high, particularly as the liquidity curve flattens.

The liquidity line is approaching a break of the 39 week moving average.  With the Fed pulling money out of the system, that break could lead to an actual downturn in liquidity that would be a crushing burden for stock prices. Even a flat trend would be burdensome for a market that would still need to absorb an average of $100 billion per month in new Treasury supply.

The CLI has risen by 4.3% over the past year. The Fed has been withdrawing money from the financial system since October. It started with tiny drains but has begun increasing their size by the schedule the Fed published in September. Those withdrawals will continue to grow over the next 5 months. That will slow macro liquidity growth and could turn it negative later this year.

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The Fed’s draining operations should have ripple effects throughout the worldwide liquidity pool that fuels stock and bond prices. The CLI is likely to turn negative soon after the Fed reaches $50 billion per month in drains from the system in October. It may even happen earlier.

Stock prices inflated by an astonishing 24.9% over the 12 months ended January 17, leading to an all-time record overbought reading on the CLI.  We therefore knew then that the market was in an extreme buying panic – a mania – from September through most of January.

The market broke in early February, ending the mania. I thought then that that decline initiated a major bear market.  Since then the market had 3 rallies, and is not in the midst of a fourth. The Treasury pumped $133 billion into the markets in mid-April by paying down debt. Despite the fact that it has begun net borrowing again, some of the cash from the paydowns is still around and it has driven yet another rally in stocks.

An extension of this rally is obviously possible, but over time, the pull of a diminishing amount of money in the system will cap the rally and send stocks into a trend of lower highs and lows. That trend will last for as long as the Fed continues to conduct its bloodletting operations.

As always, if you’re interested in the making profits on the downside of the market, in addition to our ideas here, you can check out Shah Gilani’s put play recommendations in Zenith Trading Circle.

Have a great weekend.

Lee Adler

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