Based on both my cyclical/technical analysis and liquidity analysis, I had a July 10 deadline for the end of the strong period for stocks. We’re now a week past that point and the market remains a tad higher than it was on July 10, and higher overall than I anticipated. When the market misaligns with the projected timeframe of my analysis, it’s time to ask whether I’m wrong or just early. As I do my research, that question is never far from my mind.
It’s important to always do a little post mortem when things don’t go as expected. In doing so, I try to figure out what happened and what I missed that caused the market to operate outside my expectations. That can help me make a course correction in my current forecast. At times, it can even help me recognize a new or different indicator that provides me with a deeper understanding of what’s driving the market, and where it’s ultimately headed.
While I cannot possibly account for every fluctuating input influencing the market direction, I try to recognize those that are most important.
That’s why I’ve organized a handful of the most important indicators that I’ve been using, as well as a couple that perhaps I should have given more consideration.
Macro Liquidity Didn’t Fuel the Market Rally, but This Volatile Type Did
I follow dozens of indicators, not all of which are always important. Some are important drivers at certain times and not important drivers at other times.
The most important type of liquidity is the stable supply of money created by central banks, and in lesser forms by commercial banks and sometimes the US Treasury. That is what drives long term market trends. Macro liquidity hasn’t been the driver of the recent rally. It has been going the other way.
The weakening trend of macro liquidity indicators had suggested that there wasn’t enough liquidity around to support a rally in stocks unless bonds were being liquidated. That liquidation of bonds would provide enough liquidity at the margin to support a rally in stocks. In recent weeks, the stock market had a moderate sized rally and bonds had a small rally and then held their own.
Those indicators showed that macro liquidity wasn’t the source of the cash for the stock market rally. But in watching a big stable of indicators, I saw a couple that were. I alluded to two of them last week.
One was the US Treasury injecting some of its massive cash hoard into the paydowns of T-bills. That injects cash into the accounts of dealers and other large financial institutions. Some of them use that cash to buy stocks.
Another series that correlates extremely well with stock prices is issued weekly with a 9 day lag, but its movements lead the market by 2 weeks or more. And that is useful! It is the total of US commercial bank loans to shadow banks and brokers. It’s a broader and timelier indicator than NYSE margin data, which is only issued monthly with a significant lag.
Before I get to that data let’s look at bank investment demand for securities other than Treasuries, Agencies, and MBS. This would include mostly corporate debt, with a smaller dose of municipal debt, and a small amount of corporate equities. It too has had a high correlation with the longer term direction of stock prices, often with significant lead time.
These accounts had stabilized since May, but then edged to a new low in the week ended July 4, so that needs to be watched for further deterioration. They had fallen sharply from February through April after breaking a 6 year uptrend in January. The heavy liquidation through April was consistent with the Fed pulling money out of the banking system. The banks have less cash to invest.
|This chart confirms the direct effect of Fed draining operations on bank investment activities, and thereby on stock and bond prices. These accounts are not marked to market. They are carried at original cost basis. Therefore they represent the total dollar amount invested.
It’s abundantly clear that something has changed here this year. Banks are getting out of Dodge. The long term uptrend of the holdings of these securities since 2011 has been broken decisively. Banks are not only not buying, they are actively liquidating, whether through redemptions or sales.
Stocks have been attempting to get back to their January highs despite this trend of bank liquidation of corporate (mostly debt) securities. It’s a sign not only that they lack the cash to continue to accumulate, but they also lack the confidence to hold these riskier corporate securities in lieu of holding a different class of securities.
Weaker investment demand from the banks should translate into lower securities prices. Obviously it doesn’t always work that way. The stock market rally since April is a case in point.
There are simply too many other classes of buyers in the mix with other than pure investment motivations. That includes dealers and hedge funds who are trading very short term on a variety of speculative themes, including pure technical trend following. They’re just chasing momentum.
That usually accentuates, or perhaps a better word in this case is “exacerbates,” the trend. And it virtually always involves the heavy and increasing use of margin. That leads to ugly endings. As the Fed pulls money out of the system, and increases the amount of the withdrawals in October, stock and bond prices should follow that downward curve.
Push Comes to Shove–the Fed Aims to Diminish Your Portfolio in the End
Stock prices may have gone up despite the Fed pulling money out of the system, but this isn’t sustainable. While timing of the expected decline remains at issue, the ultimate outcome is still not in doubt. Timing is mostly a matter for technical analysis, but I have recently been following a new Fed data series that helps explain the rally and may give us a heads up, or at least confirmation, on the downturn that I expect to begin soon.
The chart below shows that the liquidity that has driven this rally has come from an increase in speculative borrowing. It shows up in the Fed’s data series, Bank Loans to Nonbank Financial Institutions. It represents loans to shadow banks (can we call them “shady” banks?) and securities dealers. This data is a timelier proxy for margin. When asset prices ultimately fail to follow through on the upside, this increase in leverage will be unwound quickly and the markets will have a sharp selloff.
Source: Federal Reserve and S&P
Loans to shadow banks and dealers have risen from around $400 billion in early 2017 to around $465 billion today. The S&P 500 has moved almost in lockstep with this borrowing. We don’t need to do the math. The correlation is clearly visible.
“Shady bank” total borrowing has had a lead time of up to several weeks. So even though the data is published with a 10 day lag, it can still give us a slight jump on market moves. Notice that this borrowing dried up as the market was in its final blowoff in January. It also turned up 2 weeks before the market turned up in April. So this can be very useful in terms of timing the market, as well as in confirming the trend or calling it into question.
Right now it is calling it into question because while this borrowing is surging to record highs, the market isn’t keeping pace. Friction in the form of selling and competition from other types of financial assets, particularly US Treasury bills, notes, and bonds, is increasing. As higher bond yields and short term money rates attract more capital away from stocks, the next downturn in this type of borrowing should lead to an even bigger drop in stock prices than happened in February.
The surge of financial leverage to new highs runs counter to the Fed pulling money from the system. When it was doing this over the past 3 years, ZIRP was essentially still in force. When money is free, speculation runs rampant. With money rates now steadily rising, the pressure will build on speculators to close out positions if they are not moving profitably quickly enough.
Meanwhile, if you are looking for other trading ideas, long, short, or market neutral, check out our ideas here, or check out Shah Gilani’s put play research and recommendations in Zenith Trading Circle.