Coming back to the market. I have been trying to understand why my turnips failed me so miserably in September.
Zeev, ever since you posted about liquidity yesterday morning, I have been searching for this link.
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Liquidity and Markets:
This Time It's Different
By Joseph Carson
Today, as in the autumn of 1998, equity prices are sinking, corporate bond spreads are widening fast, Treasury yields are falling, and the dollar is super-strong. Yet what is lost in this comparison is that the economic backdrops of the two periods are fundamentally different, and so, too, should be the outcomes.
Perhaps the most striking difference between the two periods lies in the pace and direction of liquidity flows. Liquidity, as gauged by the money and financial-flows index, is much lower now, and still is decelerating. Created by the Department of Commerce almost 30 years ago but redesigned and maintained by me for more than a decade, the liquidity index measures the change in demand for money and credit based on trends in real M2 (a measure of the money supply), the change in business and consumer credit and the growth in shorthand long-term liquid assets. The grouping of several financial indicators into a composite index was done to increase the chances of getting unambiguous signals and to reduce or even eliminate false signals.
During the past 40 years -- a period that spans five business cycles of varying duration, speed and composition -- the liquidity index has established a near flawless track record of telegraphing turns in the economic growth cycle well in advance. Its strong track record over the past several years underscores its unique forecasting ability. Even as the consensus repeatedly argued that the economy would slow in the year ahead, if not immediately, the continued fast gains in liquidity flows signaled that the economy would power ahead, registering gains in real gross domestic product of at least 4%. And true to form, the economy posted real GDP gains of 4% or more in 1997, 1998 and 1999, and it is almost certain to repeat that again this year.
Even in the autumn of 1998, when the financial markets greatly raised the probability of an economic downturn in early 1999, the liquidity index signaled that the risk of recession was greatly overblown. Why? Because liquidity flows were exceptionally strong, and the U.S. economy never had suffered a hard landing when liquidity flows had been so robust.
Moreover, I argued at the time, if the Federal Reserve felt compelled to lower official rates in response to financial market dislocations, the correct investment decision would be to buy stocks and sell bonds. The proposition was clearly a risky one at the time and one that ran counter to consensus thinking. Yet based on my liquidity framework, it was the right strategy call at the time. After all, liquidity flows are highly sensitive to changes in interest rates and any sizable Fed easing would only quicken liquidity flows that already were running fast. Plainly, the economic and financial results of 1999 followed the script as forecast by liquidity trends. Real GDP grew 5%, well above consensus estimates, while corporate earnings jumped more than 17%, and the S&P 500 posted a 19.5% gain in 1999. Lucky call, some may say. Perhaps, but much more important, I think, were the 40 years of history that linked changes in liquidity flows to economic cycles, operating earnings and stock-market performance.
Today the trend in liquidity flows is decidedly weaker than in 1998. Indeed, in September the year-to-year gain was estimated to be 2.5%, the weakest gain in five years. Even more troubling is that liquidity flows have been stagnant since the beginning of the year -- the weakest nine-month stretch since 1994. Moreover, if current trends extend through yearend, the liquidity index would show no growth over a 12-month span for the first time since 1991.
Part of the protracted weakness in liquidity flows is the result of the ongoing rise in energy prices. While many analysts argue that the U.S. economy is less sensitive to oil prices than it was in years past, energy prices are still important. The economic effects of a rise in energy prices include not only the traditional loss of real income, but also new income effects, which arise from reduced company earnings, the associated fall in stock prices and the attendant decline in the value of stock options. By our calculation, the market value of stock options on the books of S&P 500 companies declined by more than $125 billion by the end of the second quarter.
Higher energy prices both drain liquidity and limit the flexibility of policymakers by raising inflation risks. Also, it is not mere coincidence that sharp decelerations (if not declines) in liquidity flows have occurred during periods marked by rises in energy prices and official interest rates. That combination almost always has proved to be deadly for the economy and the financial markets.
Rising energy prices are problematic because policy makers must guard against a spillover of those prices to other prices that would lift household and business inflation expectations. In 1998, inflation was not a concern. In fact, if there was a concern it was more on the deflation side because commodity prices were tumbling in an already low-inflation environment. Today the concerns of policy makers are fundamentally different. They are worried that ongoing increases in energy prices could lead to an environment where rising price expectations start to become a bigger factor in household spending decisions.
The upshot of all of this is that the economic fundamentals -- and thus the concerns of policy makers -- in the autumn of 2000 are dramatically different from those of 1998. Indeed, liquidity flows are slowing quickly and energy prices are rising fast, the reverse of 1998. As a result, policy makers are unable to lower rates to cushion the economy and the financial markets as they did in 1998. For these reasons it is easy to see that the coming year will not repeat the happy outcome of 1999.
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