Liquidity Growth
Will Decline
Liquidity Growth
Will Decline
Dr. George Dagnino, Editor
The Peter Dag Portfolio Strategy and Management
Since
1997 I have been following two main themes in these articles and in my Peter
Dag Portfolio Strategy and Management. The first one is that the Asian and
Latin American financial crises would play a favorable role for stocks because
of the injection of liquidity needed to cushion their impact.
The
second theme is that the economy would be much stronger than expected. The
forecasts of below average growth ignored the positive effect of rapidly
growing liquidity on consumers and business. The money supply is a concept
not in fashion anymore, but has been one of the few measures pointing to
a strong economy.
Monetary
aggregates are still growing very rapidly, suggesting the economy will continue
to surprise those who expect a slowdown. However, we may be at the beginning
of important changes.
The
world seems to be in much better shape than just a few months ago (see below)
and there is strong evidence the US has weathered the credit crunch of last
fall (see below). This change, which is good news for the economy, will
have a negative impact on the financial markets.
The
stock market, due to a high PE ratio and lower growth in liquidity, will
continue to sputter and provide below average returns (see below). Bonds
will remain weak due to low real yields and strong borrowing needed to finance
economic growth (see below). Commodities will stay weak, responding to high
real short-term interest rates (see below).
In
the meantime the yield curve will continue to steepen, providing some relief
to the banking system. Last, but not least, growth in the money supply will
decline, slowly setting the stage for the slowdown that will materialize
not before the end of the year.
The
bottom line is: stocks look less attractive, high-grade bonds even less
so, but high-yield corporate bonds are particularly attractive thanks to
the declining high-yield spread with Treasury bonds.
Stock Market: Too Narrow And Too Expensive
Can
the market go much higher? The short answer is: not much, if any. The current
PE ratio is 32 and the S&P 500 is standing at 1230 with the Dow at 9274.
The last time the PE ratio was at such lofty levels was in July, when the
market peaked and THEN declined 20%. What is interesting is that the Dow
is just below last July's levels and the S&P 500 is up only 3.7%. Since
then there has been a lot of volatility, but not much gain.
The
point is that with the PE ratio at this level, utility stocks sagging, bond
yields and volatility rising, it is difficult to be bullish on stocks.
There
is another important change taking place. Growth in liquidity is close to
a peak (see below). Liquidity has been the main engine driving this market
and its slowdown will have a negative effect on the overall market.
Furthermore,
our technical indicators point to deteriorating market conditions. Momentum
continues to wane and breadth is still negative. However, stable short-term
interest rates and weak commodities remain the dominant bullish forces.
The
bottom line is that it looks like this is a good time to become more conservative
about stocks.
Foreign Economies: Signs Of Stability
The
latest data from OECD show an improving picture for the industrialized economies.
The leading indicators of the major seven countries increased in the last
two months. Even the leading indicators for Japan, after being flat for
the past 12 months, increased decisively. This is a sign for optimism.
The
problems which worried the global central bankers in the past 12 months
are being solved. Furthermore, the socialist governments of Europe seem
to be eager to apply stimulus to their economies because of the high unemployment
rates. All this spells growth.
The
point is the problems that justified aggressive growth in monetary aggregates
are fading. The global economy seems to be improving. These are times when
stock markets rest until the next financial crisis.
The Fed: End of the Credit Crunch
In
the fall of last year spreads between lower grade corporate bond yields
and Treasury bond yields increased sharply. The unusual jump was a sign
there was a credit crunch in the making, which was confirmed by a jump in
the number of lending officers tightening loan standards.
The
Fed promptly responded by lowering interest rates aggressively and pumping
more money into the system. Monetary aggregates soared. Stocks responded
by jumping 25%.
The
increased liquidity had the desired effect to calm down the credit markets.
Spreads are now declining and the latest survey shows the number of lending
officers tightening loan standards has decreased significantly.
The
outcome has been a steepening of the yield curve, the money supply is showing
signs of slowing down and stocks are sputtering. These trends will continue
as spreads and liquidity growth decline.
Another
interesting feature of the credit cycle is that when spreads rise, the manufacturing
sector slows down due to the increased cost of borrowing relative to Treasuries.
However, when spreads decline, a sign it is cheaper and easier to borrow,
the manufacturing sector strengthens. This will become more evident in the
coming months.
Bond Yields: Up
As
I expected, bond yields are moving higher. The first and most important
reason is that real bond yields were, and still are, too low.
The
second reason is that the economy is much stronger than predicted by the
consensus. This is the same consensus which in January was expecting growth
of 2% for the fourth quarter. Actual growth came in as 5.6%.
The
good news is inflation is still dormant even if wages are rising at a 4%
pace. Productivity is strong enough for business to be able to absorb wage
increases. As a result, unit labor costs are up only 1.5% in the past 12
months in the business sector and flat in manufacturing.
The
point is the odds continue to favor higher yields ahead, but because of
low inflation they will not rise by much. This is the reason why high-yield
corporate bonds are particularly attractive right now with their 8-9% yield.
The attractiveness comes from the likelihood of lower spreads (higher bond
prices) and high yields.
Commodities: Sinking
There
is no bottom in sight. The CRB futures, the CRB industrials, energy futures,
copper and crude oil are still very weak. Lumber is the only exception among
the industrial commodities due to the solid strength of the housing sector.
Gold
is still trading in the $280-300 range. However, platinum and palladium
are up 6% and 28% respectively since mid November. Gold stocks are going
nowhere, reflecting the trend of the underlying commodity. Energy stocks
are still above important support levels, but their trend remains unattractive.
There
is no doubt this is not yet the time to invest in commodity stocks.
The Economy: Very Strong Outlook
The
data continue to paint a very strong economic environment and an improving
manufacturing sector.
The
index of leading indicators was up strongly in the past three months and
orders for durable goods soared in the past two months. Inventories are
low relative to sales, and they need to be replenished. These gauges are
saying the manufacturing sector will continue to improve.
Consumers
are in great shape. Consumer confidence rose and remains at very high levels.
As a result retail sales were up and car sales jumped 7.3%.
In
the meantime jobless claims declined and are at low levels, pointing to
a strong economy and tight labor market. Not surprisingly employment growth
is robust.
The
construction sector remains very strong as new home sales jumped and overall
construction expenditures surged.
The
enormous amount of liquidity injected in the past two years is having its
desired effect. Credit conditions are improving and the economy is strong.
The strength of the economy will continue to baffle those who are still
expecting a slowdown and continue to ignore that at the foundation of this
strength is the rapid growth in the money supply of the past two years.
The
strength of the dollar, which we expect to continue, is anticipating solid
economic conditions in the next several months.
Editor's Note: George Dagnino is editor of The Peter Dag Portfolio
Strategy & Management Letter, 65 Lakefront Dr., Akron, OH 44319,
1 year, 24 issues, $195. Visit the Web site at www.peterdag.com for
more information of this newsletter.
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