Every day we hear that the boom since March 2009 has been driven by 'liquidity'. This shrill has become all the more pervasive with the recent rally in the markets. We keep asking the question what has induced such a strong rally (apart from the usual factors such as government support as well as other technical factors). So I thought the best thing would be to research how far argument is actually backed up by solid statistical evidence. I decided that I would dig out statistics from different sources and try to find out a macro-argument for or against liquidity inducing this rally. I looked into ICI statistics and also the statistics put out by the US Federal Reserve Money Stock Measures (in billions of dollars as on 1 October 2009) and the ECB and tried to analyse (with an open mind) which way the liquidity riddle.
I kept reminding myself that liquidity is a ubiquitous but double edged sword and probably the easiest way to unfathomable market movements. I consider this posting to be part of a longer-term research in progress wherein we would like to track the flow of liquidity into different asset classes and consequently the socio-economic impact of this process.
At the outset, it is pertinent to remember that this rally directly or indirectly has the blessings of the governments the world over for the simple reason that a rally of this magnitude goes a longway in reducing the leverage on the balance sheets as well providing succour through rising assets on the books of the beleagured financial institutions of the developed world. The statistics and charts provided in this post clearly indicate that money supply creation may have slowed (at least in the USA) at best and that itself could be a red flag. Recent reports by Bloomberg claims that the European Central Bank has actually given lesser number of loans than expected.
Another argument that we can put forth is that the rally became possible (apart from the usual conspiracy theories) is not because of liquidity that has been created due to investors becoming risk averse but instead it is largely due to money that originates in the global central bank emergency measures. The results of Goldman Sachs and others clearly indicate that trading has become an important part. So we looked up statistics about margin lending and it gives credence to the view that private pools of capital are warming up to leveraging once again. Margin Debt has been increasing. This is not to claim that they were not interested in borrowing, just that there were no lenders.
It becomes increasingly difficult to argue that the rally in the equity markets worldwide was largely because of growing willingness on the part of various segments to take on more risk, or risk aversion abating. That story may only be partly correct. It becomes increasingly difficult to argue that the rally was driven by money coming out of the US Money Market funds. A small part of it may have come into the markets. The chart below clearly illustrates the fact that money on the sidelines has come down, but it is equally important to note that not all of it would have come into equities.
It has been pointed out that the amount of money shot up in the aftermath of the Lehman Crisis. The chart below show that it increased from about US$3.399 trillion to about US$3.922 trillion. A commonly held view is that a part of that is coming back into the equity markets. The Chart below (from Bloomberg) clearly indicates that even before the crisis began the amount of money in US Money Market Funds in mid 2006 was about US$2.038 trillion and after the problems with Bear Stearns in March 2007 it was about US$2.432 trillion. In early September 2008, just before Lehman collapsed it was US$3.585 trillion. Two days back it was about US$3.425 trillion. This indicates that the jump was approximately about a US$1 trillion after the problems began.
Please Click on image to expand Image
It is important is that we have to note that about US$190 billion moved into commodities, approximately US$220 billion dollars moved into bond funds.
That leads us to the important question: what led to this huge rally? Invariably short-covering played a part. But that is not to be over-emphasised. More important is the money printing as indicated by the US Federal Reserve statistics given in the table below.
We have to assume that a part this money did flow into the various markets as banks are not lending it to consumers (as some of our other posts have shown). A part of the money did go into covering the losses of the banks, while it is likely that a large component is simply being hoarded by the banks due to either uncertainty in the economy or uncertainty over their own capital requirements to cover losses in future.
The rally (in the equity markets) seems to have been fuelled by equity mutul funds putting some of their cash back into the market. The table below (from ICI) shows that the cash position of the US equity funds have largely been reduced thereby creating additional demand.
| August 2009 | July 2009 | August 2008 |
| 4% | 4.2% | 4.5% |
The following table provides us with Net New Cash Flow of Money Market Funds (In US$ million)
| August 2009 | July 2009 | YTD 2009 | YTD 2008 |
| -53,788 | -48,325 | -291,1782 | 339,548 |
Source: Investment Company Institute
One important source for the equity rally in the US has been the increase in margin debt as shown by the table below. It provides us with the annual average of margin debt for the years preceding 2009, while for the current year monthly statistics have been provided. This indicates that a large part of the rally has been induced by speculators (likely to be hedge funds) borrowing money to buy stocks. Interestingly ICI statistics show that US based equity funds have only seen inflows to the tune of about US$65 billion in 2009. In contrast the Bond funds have seen inflows of nearly US$220 billion, indicating that money moving out of the money market funds is going into bond and commodities and even emerging markets rather than US equities. Emerging market funds have seen inflows only to the tune of about US$9.68 billion on a net basis. Hedge funds on the other hand have seen inflows. Added to that is the leverage that has been built with banks lending only to them and their borrowing on the basis of margin debt. One could also add that in almost all the countries we have seen a large amount of money being pumped into the system, a large part of this invariably has entered the markets (all of them for financial speculation). A number of reports indicate this has largely been the trigger for the rally in countries such as China. The fact that a number of investors (especially mutual funds) putting some part of the cash cannot be overlooked, but should not also be overemphasised.
One important source for the equity rally in the US has been the increase in margin debt as shown by the table below. It provides us with the annual average of margin debt for the years preceding 2009, while for the current year monthly statistics have been provided. This indicates that a large part of the rally has been induced by speculators (likely to be hedge funds) borrowing money to buy stocks. Interestingly ICI statistics show that US based equity funds have only seen inflows to the tune of about US$65 billion in 2009. In contrast the Bond funds have seen inflows of nearly US$220 billion, indicating that money moving out of the money market funds is going into bond and commodities and even emerging markets rather than US equities. Emerging market funds have seen inflows only to the tune of about US$9.68 billion on a net basis. Hedge funds on the other hand have seen inflows. Added to that is the leverage that has been built with banks lending only to them and their borrowing on the basis of margin debt. One could also add that in almost all the countries we have seen a large amount of money being pumped into the system, a large part of this invariably has entered the markets (all of them for financial speculation). A number of reports indicate this has largely been the trigger for the rally in countries such as China. The fact that a number of investors (especially mutual funds) putting some part of the cash cannot be overlooked, but should not also be overemphasised.
| Year | Average Margin Debt on NYSE |
| 2000 | 243,448 |
| 2001 | 164,550 |
| 2002 | 141,003 |
| 2003 | 150,190.8 |
| 2004 | 183,287 |
| 2005 | 207,166.7 |
| 2006 | 239,572 |
| 2007 | 331,554.2 |
| 2008 | 285,168 |
| 2009 January | 177,170 |
| 2009 February | 173,300 |
| 2009 March | 182,160 |
| 2009 April | 184,120 |
| 2009 May | 189,250 |
| 2009 June | 188,140 |
| 2009 July | 199,460 |
2009 August | 206,720 |
All the above figures in $ Millions
Source: NYSE
The above analysis hopefully provides greater clarity about the the source of the rally. The important question that we need to ask is how long will the liquidity last? The short answer is that is not likely to last long (at least not beyond the next two or three months) unless the US decides that the weakness in the economy needs another round of stimulus of various kinds. That is probably one of the reasons what the commodity market is sniffing.
We would believe that most of the money that would like to enter the equity markets has already entered the equity markets and the role of liquidity is probably being overhyped. There is probably more selling that is likely rather than the other way round. Insiders are selling quite aggressively, while the investment herd seems to be buying.
While our analysis may be full of certain generalisations, we think this could be a good starting point to carry out further research and debate on the issue. Hopefully others will add to the debate.
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