Stock Market & Liquidity -- Update

As I have discussed over the past six months, when the real
economy grows faster than the broad monetary/credit liquidity
aggregate, a type of liquidity deficit develops, as the real economy
drains liquidity available to the capital markets, especially the
stock market. When this occurs late in an economic expansion cycle,
it is usually because of monetary/credit tightening by the Fed and
is normally fatal to a cyclical bull market. But a liquidity deficit can
occur during an economic expansion if economic momentum is
strong and credit growth is modest or deteriorating. We last saw
this kind of liquidity deficit from y/e 2003 through mid-2005.

When a deficit occurs as in the 18 months out from y/e 2003, it can
act as a headwind for the stock market even if earnings are
progressing well and short term interest rates are not threatening.
In the 2004 through mid-2005 case, the SP 500 advanced about
6.5% or roughly 4.3% on an annual rate basis. That is sub-par
performance.

I do not think a liquidity squeeze of the sort described above is
necessarily going to retard the stock market's cyclical progress,
but it is logical to think that it will, especially if ready portfolio
cash levels among the various funds are low. Since the latter
situation probably obtains today, it seems wise to keep the
liquidity deficit in mind.

It is likely that the current economic recovery will lose some of
its growth momentum by mid-2010, as low inventory levels are
finally replenished. Moreover, later in this year, we may see
a positive turn in private sector credit demand. Both developments
will ease the squeeze on liquidity and lessen its headwind effect on
the stock market.

Measured yr/yr, the $ cost of US production is up 1.9% after
months of deep negative readings (which created a liquidity surplus).
Looking yr/yr, my broad measure of credit driven liquidity is a
-3.7% through Jan. Thus the liquidity barometer I use is a sharp
-5.6. The deficit should increase in the months ahead before there
is a good chance for reversal.