Financial System Liquidity & Policy Risk

Liquidity
System liquidity improved in October on both fronts -- money
& credit. The narrow base of money liquidity (cash & checking)
has been growing strongly since mid-2008 and no doubt helped
to arrest the economic free fall. But, by my analysis, the US
economy is still running a cash shortage of nearly $100 bil. This
is a big improvement over the nearly catastrophic $300 bil.
shortfall that was evident in mid-2008, but I think the Fed
would be wise to allow significantly more cash to flow into the
system through 2010.

The much broader measure of credit-driven liquidity did show
some improvement over the past 2 months, as financial firms
now seem to have better access to the commercial paper mkt.

Banking system liquidity has improved from negative to
adequate, as Treasury holdings have increased and commercial
loans have run-off. The boost to balance sheet liquidity is a
necessary building block to sustain economic recovery down the
road.

Banking system capital remains constrained, but it is starting to
look like the worst of the loan loss reserving is past (Reserves
now total about 16% of capital).

Policy Risk
When the Fed loosened reserve requirements in 1992 to make
it easier for commercial banks to absorb a bevy of troubled
S&Ls, Greenspan failed to re-impose the standards after the
transition was completed. This left the banks with an array of
no and low reserve requirement deposits to fund operations and
reduced Fed control over the banking system. Bernanke also
passed on taking up this challenge.

Monetary policy has thus become grotesque -- drain cash in
a voluminous manner when credit surges, and then belatedly
rush to add cash to the system when credit stalls and falls. The
policy of raising or lowering rates in small increments has only
made the process worse. What the Fed must do going forward
is maintain a much better balance between cash and credit in
the system. The obvious choices are to broaden reserve
requirements and to move more dramatically in changing the
Fed Funds rate.

I have discussed this issue in detail several times since I began
this blog in 2005. Now, the Fed faces one of its largest
challenges ever -- managing a bloated balance sheet down as
the economy recovers. There is a large non-borrowed reserve
position in the system, so maybe the Fed can use deposit rates
to manage this position down in lieu of new, tighter reserve
system rules. We'll see.

The challenge has not been tried before, so elevated risk is
involved. The best outcome for the Fed would be to be more
decisive in raising rates and to maintain a better balance
between cash and credit in the system as the economy
recovers. Given the 2 credit tightening debacles we have
seen over the past 10 years, I would strongly favor tougher
reserve mangement and an end to "baby step" rate changes.
These two steps might ameliorate the need to boom and bust
the cash mangement in the system and provide for more
stability in the execution of policy.

Economic Indicators

Leading Indicators
Both weekly and monthly indicators remain positive, although
there has been modest loss of momentum in both categories. The
leading indicators are still signaling a "V" economic recovery.

Business Strength Index
This index has rallied strongly since early 2009 and indicates
economic output has turned positive. The Fed prefers to tighten
credit when this index rises up into a range of 130 - 140. Current
reading is 126.7.

Economic Power Index (EPI)
The index is built off wage and employment trends. The news is
not good here. After historically strong performance over Half 2
' 08, the real wage is now running a more subdued 2.4% yr / yr.
The job market is weak, health care insurance premiums have been
strongly boosted and deflation has subsided yr / yr.

Much worse, total civilian employment continues southward, and is
now down a hefty 4.4% yr / yr. From the late 2007 peak, 5.7% or
8.4 million people have lost their jobs. This puts the EPI at a weak
-2.2% through 10/09. The low yr/yr EPI reading contrasts with
the broader real disposable income measure of +0.5% for the
comparable period and shows you the importance of tax cuts,
higher gov. spending and the automatic stabilizers in supporting
recovery from the income side.

From a micro perspective, the stock market has rewarded earnings
rebounds from harsh cost cutting by pushing up company share
prices. From a macro perspective, this policy is proving injurious
for economic recovery potential as incomes and purchasing power
are being eroded at home. Moreover, without a turnaround in
hiring, there will be pressure for another sizable gov. stimulus
program to counter the growing weakness of employment.
In the short run, companies are pleased with an abnormal surge in
productivity growth, but in the long run, the economy and the stock
market will suffer without stronger employment. Smart micro,
dumb macro. Employment link.*

Capital Slack Measure
This is a measure of the degree of idle resources in the economy.
It incorporates plant utilization, idle worker levels and interest
rates. This measure is at its lowest since prior to WW 2, and
reflects the depth of the recession experienced.

Global
The global activity and leading indicator measures are up sharply
in 2009, and very much mirror the US experience. The indicators
suggest the global economy bounced from deep recession mode over
Half 1 '09 and moved into recovery mode in Aug. Progress on
employment abroad has been much slower than the recovery of
output.
-------------------------------------------------------------------
* If link does not hold up, go to bls.gov employment series for
total civilian employment.

Monetary Policy

As was widely expected, the Fed has left policy unchanged. ZIRP
stays. The economy has turned up, and the breadth of businesses
reporting higher activity levels has risen sharply, especially in
manufacturing. The monthly data is volatile, but the economy has
cleared the first hurdle toward a decision to boost rates. However,
plant utilization is a full 10 percentage points below levels where
the Fed generally raises rates. The Fed is thus holding to the
historic view that much higher levels of resource utilization are
required to warrant a firming of monetary policy. As well, my
short term business credit supply / demand balance is very soft
as loans continue to roll off the books in reponse to much lower
working capital needs. This can continue, as businesses often
generate sufficient internal cash flow to handle early stage
recovery needs. My yr / yr measure of broad credit driven
liquidity is still down in % terms. Thus the Fed and the Treasury
remain the primary providers of increments to liquidity in the
financial system.

With the CPI at a + 2.6% annual rate through Sept., real short
rates are negative and continue to be hosed. Thus the US dollar
is losing purchasing power at home. For now, the Fed, in moving
to liquify the system and keep interest rates low, is running well
behind the inflation curve.

Pundits have made much of the postive slope of the yield curve
and how it, through a positive cost of carry, as well as the ZIRP
policy, are funding a recovery of asset values. This is a normal
cyclical development, and the liquidity available for asset
speculation will dry up as the real economy recovers and claims
additional liquidity. In fact, you have to be careful with this since
financial liquidity, when measured broadly, has been contracting.
This means that as the economy improves, the velocity of money
is rising from low levels and that excess liquidity is contracting from
high levels. Talk of "asset bubble" conditions is decidedly early,
to say the least.

Stock Market -- Technical

The market has entered a short term correction, but it has not
weakened enough to change it from a consolidation phase into a
more vulnerable one. The correction is indicated by breaks of
the market and its 10 day m/a below the 25 day m/a and the fact
that the 25 day m/a is starting to roll over (See chart link below).
The SP 500, now 1045, would fall out of consolidation below short
term support of 1025.

The market, on my measures, is only modestly oversold at current
levels, and would need to fall to the 1010 - 1020 range to give a
stronger, more respectable oversold reading. That range would
also be equal to a 7 - 8% correction off the 10 /15 rally high of
1097 (closing). An 8% pullback represents a goodly shorter term
correction in a cyclical advance.

Since the market has broken its uptrend line from 3/09 and since it
failed to take out trend resistance dating back to the '2007 highs,
we have a situation that commands attention.

I would also note that I have a sell signal from my smoothed 40
wk. oscillator, which went definitively positive in mid - March ' 09
and stayed that way until this past Fri. This indicator can whipsaw
like any other, but long experience says a change in direction is
well worth attention. This is a momentum oscillator which puts
weekly closes against the 40 wk m/a and which is smoothed out to
13 weeks.

I will happily concede that the market can confound the short term
situation by swinging back into rally mode, but my work is now
flashing amber or caution.

Looking long term, this upleg since 3/09 represents one of the
more powerful 6 - 7 month advances in history and the market
today is trading well above levels indicated by a more typical
cyclical advance. From a historical perspective, it is wise to
figure that this powerful upleg will transform into a more normal
one at least for a while, but just how that situation may eventuate is
something that one can probably only guess at. I have been thinking
that there could be another leg up to the current advance before a
more rugged correction takes hold, but that awaits resolution of
this current cautionary period which I have been looking for since
mid - Sept. '09 (See 9/20 post).

Sp 500 chart.

Economic Momentum Expectation Measure

The relative strength of the MSCI Cyclicals index vs. the broader
SP 500 gives a good insight into investor expectations for the pace
of economic growth ahead. Chart.

$CYC relative strength turned up with the market last spring and
has vaulted back up to the historic long term high range. So, we
are seeing technical resistance and the possible beginning of a
cooling in growth expectations. The $CYC RS line does fit well
with the weekly leading economic indicator sets in that they are
flatlining in the short run as well.

The chart shows a slight break of short term support for $CYC RS
and it thus raises the question of whether portfolio managers are
at the early stage of thinking through whether rotation into more
stable earnings prospects companies might be appropriate. Keep
this yellow flag in mind re: cyclicals.

Back on 9/20, I turned cautious on the shorter term outlook for
the stock market and decided to take a trading holiday for 6 weeks
or so. I mentioned then that positve earnings surprise for Q3 ' 09
might lift stocks higher in the interim but that a period of either
consolidation or correction probably lay ahead. We got the bounce
from earnings as expected and we are now seeing some weakness.
I'll pick up more intensive coverage of the broad market again next
week.

Gold Price

As discussed in the last gold post on 9/10, I pointed out that the
gold price needed to take out key resistance at $1000 oz. to hold
the uptrend in place since 10/08. This it has done.

The gold price was rambunctiously up over Q1 '09, but it could not
hold that action and has since settled into a more stable uptrend.
The negative price action of the past few days has taken some of the
froth off the market, but gold has not been dizzyingly overbought
now since a brief stretch in 3/09. I would rate it mildly overbought
at this time.

My gold price macroeconomic directional indicator entered a new
uptrend starting last December. It has been rising with relative
consistency and reached a new all-time high on 10/23, slightly
exceeding the previous high set in 8/08. The primary factor
behind the setting of a new high has been the strong growth of
monetary liquidity via the Fed's easing actions, but oil and industrial
commodities prices have also contributed significantly since the
early part of this year.

It is encouraging that gold and the indicator made new highs close
in time to one another, but I continue to see gold as carrying a large
price premium that I cannot account for through various techniques
of economic analysis. That premium is now close to $350 an oz.
It is clear that there is no shortage of folks who worry about the
stability of the financial system. But, I would also point out that
2009 has seen sharp advances for the other precious metals, so
there could be as much a cyclical element in gold's recent trend as
anything else.

At any rate, gold remains too rich for my blood, and I have been
happy to trade away from this market and will continue to do so
until gold finds a range closer to my idea of its economic value (now
a paltry $500 -550 oz.). Gold chart is here.

More On SP 500 Profits

This entry builds from the 10/21 post on earnings. With
earnings in recovery mode, analysts now see quarterly
operating net improving serially straight through the
final quarter of 2010, and they expect full year SP 500
eps for 2010 to be up by 31% to about $73.50. Now, this
represents a fairly strong takeoff, and as discussed in the
10/21 post, suggests that profit margins will benefit from
a positive turn in top - line or sales growth. Looking out
to Q 4 ' 10, the consensus is for quarterly net of about
$20.20. This is hardly a stretch with modest real growth
in sales of 3% and a pricing gain of 2%. So, I do not think
the numbers needed to produce much stronger earnings
in 2010 are heroic by any stretch.

For perspective, should Q 4 ' 10 eps come in at $20.20, we
can compare that number to a mid - range $25. based on
the SP 500 earnings channel for the past 20 years. The
projection represents good recovery from severely
depressed levels, but would fall far short of the indicated
norm of the past 20 years.

You should know that earnings projections through 2010
are somewhat backloaded in that no big lift is expected
until mid - 2010. So, as analysts now see it, the big test
of their projections is still 9 months out.

I think the above fairly presents the earnings
fundamentals game plan out through 2010. It looks
daunting, but really represents a "lay up" with a modest
modicum of economic recovery.

I think investors are clearly looking well into 2010 with
the SP 500 at current levels. And that is an important
takeaway for you as you assess the economic outlook for
yourself from week to week and month to month.