This Liquidity/Sentiment Indicator Shows Little Enthusiasm For This Rally

The market’s vicious October rally has been lifted on a rising tide of liquidity, with only a tepid rise in bullish attitudes leveraged to that.

The Equities/Cash Preference Index (ECPI) is a ratio of the S&P 500 to total cash-like (both demand and time) deposits in the US banking system. By measuring how much stock prices rise or fall relative to the total level of banking system liquidity, it helps us to identify when trader sentiment is overextended with or against the trend.

 

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The August selloff and retest resulted in both the S&P 500 and this ratio reaching long term trendlines (Technical analysis really is pretty simple). The furious rally in stock prices since then has been far less impressive on the ECPI, which remains well below its 52 week moving average. Depending on whether the indicator rises back above its 52 week moving average, it should give us some indication of whether the long term trend of rising equities preference is shifting.

The picture here tells us that the big rally this month has been built on the rising tide of liquidity in recent weeks rather than a sharp increase in enthusiasm for stocks. That cuts both ways. It leaves a lot of room for an additional rise in prices if sentiment does begin to become more bullish and traders decide to commit more of their cash to buying stocks.

But if the indicator rolls over below the 52 week and 104 week moving averages, it would support the thesis that the long term trend of sentiment is turning less positive toward stocks. In that case, rising banking system liquidity would have less and less impact on stock prices. Ultimately, stock prices might decouple completely from the liquidity trend, just as oil and other commodity prices have done in the past year.

Sentiment and liquidity go hand in hand and trader attitudes can and do change over time. Rising liquidity tends to foment increasingly bullish attitudes and behavior. That can cause liquidity to increase even faster as speculators and business increase the leverage ratio of their collateral. In other words they borrow more and buy more. That’s what credit bubbles are about.

But the process can also work in reverse. When some speculators and businesses become suspicious of current conditions they begin to delever. They sell assets and pay off loans. That extinguishes deposits and liquidity growth begins to slow. If that trend gains a foothold, systemic liquidity may stop growing completely, and on rare occasions liquidity may begin to decline. The process of falling liquidity actually begins with a subtle shift in the attitudes and behavior of a few market actors.

Under the current circumstances, we could see overall macroliquidity levels begin to decline as economic actors and leveraged speculators opt to pay down debt and delever if they grow increasingly suspicious of the current level of stock prices relative to the underlying conditions, including how they view the ability of central banks to keep stock prices levitated.

Eventually, shifting attitudes lead to changes in market behavior, which ultimately may evolve into forced liquidation. As prices fall, collateral values fall and the margin calls go out. That actively destroys money and liquidity as deposits are used to pay down outstanding debt. Whether central banks would deploy enough monetary armament to offset that would depend on whether enough traders believe that it will work.

We’re seeing hints that some traders are starting to jump off that “faith in the central banks” bandwagon, the bandwagon that we first recognized 6 1/2 years ago. In the weeks ahead we should learn just how far the old bandwagon can take us before the wheels fall off.