Liquidity Impact On The Stock Market

All three major indices have continued their rallies in June: The S&P 500 is up 2.23%, the Dow Jones Industrial Average is up 3.54%, and the Nasdaq composite is up 1.33%.

The S&P 500 has marked a 42% return since the March 23rd low for the large-cap index, while the Nasdaq Composite is only 2.26% from its all-time high. Although there are a few possible explanations for the performance (e.g. there could be a vaccine ready by the end of 2020; states are reopening without a spike in infections, etc.), there is one important factor we can’t ignore: Fed liquidity.

The Fed has provided massive liquidity to calm the markets since the outbreak of COVID-19 in the US. In its April announcement, the Fed said it could pump $2.3 trillion into the economy through various programs, resulting in a total injection that would exceed its 2008 rescue. Years ago, academic research found liquidity to be an important factor affecting equity returns (Brennan and Subrahmanyam, 1996; Keene and Peterson, 2007).

But, measuring the liquidity premium in the equity market is still methodologically arduous, especially for Fed-injected liquidity; mainly because of the lack of liquidity measures and the incompleteness of liquidity data. Some common liquidity measures include trading volume, share turnover, etc. In addition to the academic measures, there are some fresh views that may be more tailored to gauging the impacts of the Fed’s actions to provide liquidity.

The first measure is money zero maturity (MZM). MZM represents the liquid money supply, such as cash or money in checking accounts.

As shown in Chart 1, the S&P 500-to-MZM ratio has averaged 6.04 since 1990, with its all-time-high of 14.04 on March 9th, 2009 – the market bottom of the financial crisis. The ratio fell to its lowest point since the 2008–2009 financial crisis on February 10th, 2020, right around the S&P 500 all-time high. With the Fed’s liquidity injection since then, the ratio has bounced above 7, a bullish signal for the equity market.

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Disclaimer: The preceding was provided by Cumberland Advisors, Home Office: One Sarasota Tower, 2 N. Tamiami Trail, Suite 303, Sarasota, FL 34236; New Jersey Office: 614 Landis Ave, Vineland, NJ ...

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