Liquidity Cycle

Peak US system liquidity growth (including the Fed's balance sheet) hit 11.6% yr/yr in late
2013. Through June it is down to 9.4% yr/yr and by year end 2014 it will be an estimated
7.1% yr/yr. The powerful growth of liquidity from late 2013 through mid - 2014 strongly
suggested faster economic growth through the year, and we have seen that in the monthly
data so far save for bad winter related weakness in early 2014. System liquidity growth will
perhaps slow further in 2015, so the economy and business profits may have less of a positive tailwind as 2015 develops.

As QE 3 zeros out, a major source of easy money support for the stock market will have ended.
The SPX rose 30% last year when QE was in full bloom, but is only up about 6.5% this year
despite a slower but still bountiful pace of QE. My view has been that the wind-up of this
large program by the Fed would suppress the market's p/e multiple and perhaps substantially.
So far this year, the SPX has held up pretty well especially given that players are factoring in
the cessation of securities purchases that are additive to Fed assets by late 2014. It is fair to
say that so far this year, investors have ceased aggressively chasing stocks, but they do not
seem to be very intimidated by the withdrawal of this major source of strength for the market
since the bull began in early 2009. That may change as the zero hour approaches late this
year, and it would not be surprising if it did. But for now, confidence in the economy and the
markets is holding up pretty well.

The US is still a heavily leveraged economy and the Fed went to large QE programs and a
ZIRP to keep the deflation wolf away from the door so as to avoid a downward spiral of
deflationary debt liquidation that would have produced a deeper depression. It has been five
years since the economic emergency that prompted the Fed's actions and although the
recovery has been slow, perhaps there is enough confidence throughout the system and its
markets that these programs can be laid to rest and more normal policies pursued. If it turns
out to be a case where short memory works to our advantage, my extra caution will have
been misplaced.