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Liquidity The Most Important Fundamental
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Liquidity: The Most Important Fundamental

I’m sure you’ve heard analysts, financial pundits, and other babbling heads yabber on and on about how these markets don’t reflect the “fundamentals”.

They’ve ranted non-stop about how the fundamentals prove that a bear market is around the corner.

They’ve raved about valuations being stretched and how stocks will collapse any day now…

If you’ve been taking investment advice from these doomsdayers, then please accept my condolences for your portfolio loss.

These broken clocks should heed the words of Mark Twain:

Denial ain’t just a river in Egypt.

No, denial is not just a river in Egypt, it’s also the perpetual state most market participants live in.

Now I’m not bashing the usefulness of what are commonly thought of as fundamentals. Things like earnings per share, book value, and revenue growth are indeed important.

What I’m saying is that these are only a few pieces of a much larger puzzle.

The dictionary defines the word fundamental as, “a central or primary rule or principle on which something is based.”

If there’s one “central or primary rule” on which all fundamentals are based, it’s liquidity. Liquidity is the Mac-Daddy of fundamental inputs. And not surprisingly, it’s the least known and understood.

Here’s one of the greatest of all time, Stanley Druckenmiller, on the importance of liquidity (emphasis mine):

Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.

So what is liquidity exactly?

In simple terms, liquidity is demand, which is the willingness of consumers to purchase goods and other assets. This demand is driven by the tightening and easing of credit.

What we usually think of as money (the stuff we use to buy things) is comprised of both hard cash + credit. The amount of hard cash in the system is relatively stable. But credit is extremely elastic because it can be created by any two willing parties. It’s this flexibility that makes it the main factor in driving liquidity/demand.

The majority of credit, and therefore money, is created outside the traditional banking sector and government. Most is created between businesses and customers. When businesses purchase wholesale supplies on credit; money is created. When you open a Best Buy credit card to purchase that new flat screen TV; money is created. And when you purchase stocks on margin from your broker; money is created.

The logic is simple. The more liquidity and credit in the system, the more demand, which in turn pushes markets higher.

Which leads us to our next question: What are the largest levers that affect the amount of credit, money, and liquidity in the system?

The answer to that is interest rates. These are set by both central banks and the private market.

The primary rate set by central banks is the largest factor in determining the cost of money. And the cost of money in turn determines liquidity/demand in the system.  

When the cost of money is low (low interest rates) more demand is created in two ways: [1] it makes sense to exchange lower yielding assets for riskier, higher yielding ones and [2] more people are willing to borrow and spend (money is created) because credit is cheaper.

This affects the stock market in two ways: [1] share prices rise as investors trade up to riskier assets and [2] companies’ total sales increase because of higher consumer demand caused by cheaper credit. Liquidity affects both the denominator (earnings) and numerator (price per share) in stock valuations as it drives markets higher.

You may be asking yourself, “well, if the primary rates set by central banks are this important, then will markets stay forever inflated as long as they keep rates low?”

No, they won’t.

Though central bank rates are the largest influence on demand and the cost of money, they are not the only influence.

The private sector assigns its own rates based off the central bank rate, but also includes an additional premium (or spread) that fluctuates according to the credit risks they see in the market.

For instance, even though the Fed Funds rate has remained near zero over the last two years, interest rates on high-yield loans (the primary lending market to the energy sector) ballooned during the recent oil collapse because of increased perceived risks. Money tightened and became more expensive as liquidity became constrained in that sector. This type of liquidity tightening is what causes markets to fall, regardless of whether the primary rate is low or not.

The way liquidity ebbs and flows directly affects market narratives.  

The 2008 financial crisis occurred because central banks cranked up liquidity to jumpstart the economy after the 2000 tech bust. All this extra money got dumped into housing. That’s how the bullish real estate narrative was born. Eventually a bubble formed and later popped as liquidity dried up.   

And of course the central bank’s response was to ease even more. They’ve now kept the liquidity spigots blasting longer than any other time in history. As long as liquidity conditions stay positive, we can expect the bulls to keep running.

Like Druck said “It’s liquidity that moves markets.” Bull markets, bear markets, everything.

Knowing how to gauge liquidity is the number one thing you can do protect your capital and profit.

To learn more about gauging liquidity, download our investment handbook here.

 

 

The Capital Cycle
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How The Capital Cycle Works

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

If you’ve been following Macro Ops for a while, then you know the Bridgewater Debt Cycle model is the foundation for how we view larger market movements. The debt cycle drives the short-term business cycle (5-8 years) as well as the longer-term secular cycle (50-75 years).

Here’s how it works:

  1. The central bank lowers interest rates, bringing down the cost of money
  2. This lower rate feeds into the rest of the economy, bringing down lending rates
  3. Borrowing becomes cheaper and more attractive, driving consumers and businesses to borrow and spend more (boosting demand)
  4. Existing debt becomes cheaper to service, leaving consumers and businesses with more income to spend (boosting demand)
  5. The discount rate at which businesses and financial assets (risk-premia spread) are valued is lowered, increasing the present value of assets, which creates a flow into riskier assets (boosting demand)
  6. Since one person’s spending is another’s income, a wealth effect is created and credit profiles improve, allowing consumers/businesses to borrow and spend more, creating a virtuous demand cycle

Eventually, central banks raise interest rates and the feedback loop shifts into reverse, until interest rates are lowered once again and the cycle starts anew. Short-term debt cycles compound into long-term debt cycles. This is how demand spawns and how bull and bear markets are born and die.

Again, if you’ve been following us for some time, then you know that we’re in the tail end of the current short-term debt cycle. And this short-term debt cycle is on the backend of the long-term debt cycle. This means we’re in the early stages of a secular deleveraging, which is why growth has been so elusive and also why Western politics have been so populous (a period not unlike the last secular deleveraging in the 1930’s).

The Debt Cycle model looks at everything from a demand perspective. But we can also look at these cycles from the viewpoint of supply. Doing so gives us greater granularity of the forces at work. Read more

How Short-Term and Long-Term Debt Cycles Work
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How Short-Term and Long-Term Debt Cycles Work

Conventional economic “wisdom” fails to understand the role of credit/debt in our market based system. Mainstream economics completely neglects to understand not only credits affect on demand, but also how this credit demand fluctuates in both short and long-term cycles. Read more

Bridgewater
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Bridgewater’s Five Stages of a Sovereign’s Life Cycle

According to Ray Dalio (and we believe this as well) there are four drivers of economic growth: culture, indebtedness, competitiveness, and luck.

And the two most positive influences on these growth drivers are [1] the psychological framework that creates people’s desire to work, borrow and consume and [2] war.

It’s these different socioeconomic experiences that form long-term cultural and psychological biases. These biases in turn drive the cycle of a nation’s economic growth, power, and influence — all in a very complex and reflexive loop.

Here’s Bridgewater’s explanation of the five different stages of this process in a sovereign’s life cycle: 

1) In the first stage countries are poor and think that they are poor. 

In this stage they have very low incomes and most people have subsistence lifestyles, they don’t waste money because they value it a lot and they don’t have any debt to speak of because savings are short and nobody wants to lend to them. They are undeveloped.

2) In the second stage countries are getting rich quickly but still think they are poor.
 
At this stage they behave pretty much the same as they did when they were in the prior stage but, because they have more money and still want to save, the amount of this saving and investment rises rapidly. Because they are typically the same people who experienced the more deprived conditions in the first stage, and because people who grew up with financial insecurity typically don’t lose their financial cautiousness, they still a) work hard, b) have export-led economies, c) have pegged exchange rates, d) save a lot, and e) invest efficiently in their means of production, in real assets like gold and apartments, and in bonds of the reserve countries.

3) In the third stage countries are rich and think of themselves as rich.
 
At this stage, their per capita incomes approach the highest in the world as their prior investments in infrastructure, capital goods and R&D are paying off by producing productivity gains. At the same time, the prevailing psychology changes from a) putting the emphasis on working and saving to protect oneself from the bad times to b) easing up in order to savor the fruits of life. This change in the prevailing psychology occurs primarily because a new generation of people who did not experience the bad times replaces those who lived through them. Signs of this change in mindset are reflected in statistics that show reduced work hours (e.g., typically there is a reduction in the average workweek from six days to five) and big increases in expenditures on leisure and luxury goods relative to necessities.

4) In the fourth stage countries become poorer and still think of themselves as rich.
 
This is the leveraging up phase – i.e., debts rise relative to incomes until they can’t any more. The psychological shift behind this leveraging up occurs because the people who lived through the first two stages have died off or become irrelevant and those whose behavior matters most are used to living well and not worrying about the pain of not having enough money. Because the people in these countries earn and spend a lot, they become expensive, and because they are expensive they experience slower real income growth rates. Since they are reluctant to constrain their spending in line with their reduced income growth rate, they lower their savings rates, increase their debts and cut corners. Because their spending continues to be strong, they continue to appear rich, even though their balance sheets deteriorate. The reduced level of efficient investments in infrastructure, capital goods and R&D slow their productivity gains. Their cities and infrastructures become older and less efficient than those in the two earlier stages. Their balance of payments positions deteriorate, reflecting their reduced competitiveness. They increasingly rely on their reputations rather than on their competitiveness to fund their deficits. They typically spend a lot of money on the military at this stage, sometimes very large amounts because of wars, in order to protect their global interests. Often, though not always, at the advanced stages of this phase, countries run “twin deficits” – i.e., both balance of payments and government deficits.

5) In the last stage of the cycle they typically go through deleveraging and relative decline, which they are slow to accept.
 
After bubbles burst and when deleveragings occur, private debt growth, private sector spending, asset values and net worths decline in a self-reinforcing negative cycle. To compensate, government debt growth, government deficits and central bank “printing” of money typically increase. In this way, their central banks and central governments cut real interest rates and increase nominal GDP growth so that it is comfortably above nominal interest rates in order to ease debt burdens. As a result of these low real interest rates, weak currencies and poor economic conditions, their debt and equity assets are poor performing and increasingly these countries have to compete with less expensive countries that are in the earlier stages of development. Their currencies depreciate and they like it. As an extension of these economic and financial trends, countries in this stage see their power in the world decline.

Which stage would you say the US and the rest of the developed markets are in?

Understanding these large secular dynamics is essential to fully grasping the interesting economic times we now find ourselves in.

 

 

Spread
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Spread Thin — How The Fed Manipulates Financial Spreads

“The Fed is manipulating markets…”

“Central Banks are destroying capitalism…”

“Yellen has distorted true price discov… yada-yada-yada”

We’ve all heard the constant chorus of central bank bashing. The ridicule comes from a diverse crowd, ranging from retail Joe Schmoes to prominent hedge fund managers… and I admit, Fed economists make for easy targets. Read more

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Who’s Buying And Why? — The Transactions Approach

Theory turns toxic when institutionalized.

Need an example?

Just look at modern economics.

Economists surround themselves with models that are supposed to predict everything from inflation growth to GDP.

But do they work?

Eh… not usually. Read more