Water Water Everywhere

In response to Tony’s piece comparing the Euro, SPX and US Bond market, I have a few observations that hopefully will be additive. The old saw that correlation does not imply causation is reflected in John’s comments that the relationships between macroeconomic variables have and certainly will change over time in different markets. Of course, that does not prove that their current correlation doesn’t make sense or can’t be extrapolated forward, it just means that over time these relationships can change entirely.

In searching for a fundamental reason why an appreciation in the Euro vs the US$ would impact the SPX, the most talked about microeconomic thesis for this is the earnings benefit such weakening of the US$ brings; earnings for US multinational corporations would be better thanks to the favorable exchange rates and the more competitive products and services from US companies. Indeed, many companies that have reported over the last few quarters have suggested that favorable FX rates have helped boost earnings on the margin.

This argument, prima facie seems (1) to make sense microeconomically, (2) to explain the relationship between the Euro and the SPX, and (3) to have been borne out in reality with recent earnings reports.

But here’s the rub. Germany is, arguably, Europe’s weakest economy; the UK the Euro zone’s strongest (relative basis). Despite the Euro rising 12% from March to June against the US$, and thus hurting the exports from these two economies, the German DAX index gained 40% (and is now up 61%); the FTSE 100 gained 21% in that time (and is now up 25%).

How, you might ask, can a depreciating currency benefit one country (the US) while an oppositely appreciating currency also benefit the counterpart? The answer, not surprisingly, is that there is something else going on entirely to cause the substantial moves in both the US stock indices and their counterparts in Europe.

The only thing that matters – the single most important observation that must be understood in this stock market, in world stock markets - is this: liquidity.

Central banks worldwide are flooding their banking systems with excess credit. In this regard the Fed has no monopoly. Indeed, for those of you that are fans of Federal Reserve data releases, you’ll have noticed one interesting tidbit: the excess reserves as a % of total reserves figure reached an historic high two weeks ago: 12%, exceeded only by the emergency measures taken by the Fed after 9/11 when excess reserves reached into the low 50%s. Prior to that, fear of a possible Y2K-related technology failure caused the Fed to increase excess reserves in the banking system to 7% right before the millennial change over. So whatever the Fed is doing – preempting deflation, getting Bush re-elected, whatever, - they are doing it with a gusto not seen this century save for only 1 other time: 9/11.

So the DAX rising more than the UKX makes total sense in this liquidity-raises-all-boats environment; it was the worst performer up 'till then.  And if you think there isn't a parallel in the US you'd be wrong.  The best US stocks since the March low, as a group, have been the lowest priced quintile. No other factor has mattered: not market cap, not short interest, not industry, nothing. Just a low price. That's what liquidity does.

John’s point that sentiment and liquidity are primary causative agents for stocks price movement is spot on. The only question now is how long they both can last. It can’t be forever, but the longer they do, the more terrible the price to be paid.