Stock Market & Financial Liquidity

Measured in 12 month intervals the US economic recovery has been at a far faster pace than
has the growth of my broad financial liquidity composite since late 2009. The resulting liquidity
"deficit" primarily reflects the shrinkage of private sector credit demand which has reduced the
need for funds in the system. This has created a headwind for stocks. This headwind has eased
substantially since the spring of this year, but it remains appreciable. Looking forward, the
decision by the Fed to buy an additional $600 bil. of Treasuries through mid 2011 will ease
the strain on the broad measure of financial liquidity, which increased by a tiny 1.2 % yr/yr
through 11/10 (and was essentially flat adjusted for inflation). But that $600 bil. pool will
be subject to claims by the real economy as well as the capital markets, so contrary to what
a number of commentators have said, it's not all gravy for the capital markets or the inflation
rate, for that matter.

The leading economic indicators point to a continuing acceleration of the pace of economic
recovery in the months ahead. Moreover, inventory investment by business, which badly
lagged the economy during most of the current recovery, has been catching up. Now, the
recovery of business sales and continued cost cutting has provided a sizable surge of
business sector cash flow which has been more than sufficient to fund expanding working
capital requirements, and, we will have to see whether rising new order books can
continue to be funded internally or whether business will need to increase shorter term
borrowing for working capital and to invest more in adding new workers.

Increased business borrowing would add credit based liquidity to the system, and that
would, other things held equal, diminish further the headwind the stock market faces.
Naturally, this more normal funding activity would come at a cost down the road in the
form of higher short term interest rates. But since rates are so low, the stock market
can accomodate the early phase of rising rates.

Investor caution and the liquidity headwind the stock market faces have trimmed 1.5
points off the p/e multiple based on 2010 earnings by my reckoning. We shall have the
headwind in place as we move into 2011.