The relationship between US liquidity (red line) and US stocks (yellow) has been clear historically: stocks sell off as liquidity is drained from the system, and only become buoyant again when liquidity floods in again. And with liquidity still pouring out of the system, stocks are unlikely to have bottomed out.
Liquidity is essentially all the credit and capital that flows through the US economy. It represents the total sources of funds available to the private and public sectors to help them function and grow. The positive relationship between liquidity and stocks makes sense: when liquidity is ample, governments and companies can easily (and cheaply) fund expansion projects and grow much faster than they would otherwise. When liquidity contracts, loans become harder to get or refinance, and economic activity grinds lower. It doesn’t happen immediately, mind you: changes in liquidity generally take months to show up in the economy and stock markets. This is why liquidity is such a valuable leading indicator: by monitoring today’s liquidity conditions, we can predict what happens next to stocks and economic growth.
Right now, US liquidity is ebbing – as interest rates rise and credit conditions tighten. Historically, that’s been bad for stocks: they’ve generally lost a quarter of their value in this environment.
And historically, what happens next is really interesting: when the Fed eventually pivots and goes back to injecting liquidity into the system, stocks tend to experience a temporary market rally – followed by another crash of about 17%. It’s only when liquidity becomes flush again that stocks rebound. Put more simply: buying stocks while liquidity is removed from the system, or immediately after the Fed pivots hasn’t worked out too well historically. So you might want to wait until liquidity is ample again before going in again. And with the Fed still hiking interest rates, and liquidity still draining, that moment is likely still a ways off. And the bottom for stocks is likely still not in sight.
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