Here's How I Know the "Red Light" Is Coming Soon

I have studied and reported on the correlation between the direction of liquidity, what was going on in the U.S. banking system, and stock prices for the past 15 years.

As you know, my efforts culminated in the development of the LAMPP indicator, which reduces the most important sources and uses of liquidity in the U.S. market to a simple red light, yellow light, green light system that requires little interpretation. I update that indicator here for you every Monday.

Right now, the LAMPP is on yellow and getting perilously close to turning red (even before the Fed begins to reduce the size of its nearly $4 trillion balance sheet).

Here's exactly how I know...

The Composite Liquidity Indicator

While the LAMPP focuses on flows from the Fed and the U.S. Treasury, I have created dozens of other proprietary indicators to help me to fill in the blanks to better understand what is driving the trend and what's likely to cause the trend to change direction.

Often, these indicators can give us a clear signal that things are about to change.

About 10 years ago, I combined what I felt were the most important of these indicators into what I call the Composite Liquidity Indicator (CLI).

My proprietary CLI combines five different measures of U.S. systemic liquidity. All are published weekly, enabling us to see the progression of the trend on a weekly basis, with minimal lag.

In short, the CLI attempts to capture every macro source of money that would have an impact on the U.S. stock market.

Here's what's in it and how it works...

The most important component of the CLI is a measure of the cash flowing from the Fed to the Primary Dealers (also one of the two components of the LAMPP).

This is a real-time indicator, published one day after the end of the weekly statement period. We have the additional advantage of knowing not only where it is now, but where it will be for the foreseeable future because the Fed gives us a detailed schedule of its monetary activities!

Other components include a measure of U.S. bank deposit growth and several measures of commercial bank trading and investment activities. Finally, I include the measure of direct foreign central bank purchases of U.S. securities. I plot the value of the indicator on a chart and overlay the S&P 500.

Unsurprisingly, the indicator and the markets move together; stock prices follow liquidity.

As you can see from the chart below, stock prices stayed within the red band surrounding the liquidity indicator from 2009 to 2016.

Whenever stock prices reach the outer edge of that band, they tend to reverse. That relationship broke in January 2016 when stocks had a big sell-off. A new, wider band formed.

The S&P 500 has now exceeded the upper edge of the band, which tells me that the market is "overbought" or that stock prices are overextended relative to the trend of liquidity.

The CLI has risen by 3.5% over the past year, while stock prices have inflated by nearly 11.5%, leading to record overbought readings. The recent upside extension of the market has even exceeded the degree to which the market was oversold versus liquidity at the February 2016 bottom.

But there's a significant difference between the February 2016 oversold reading in the CLI and today's overbought reading. The 2016 move was counter trend, while the current overextension is in the direction of the trend.

That can support overbought readings for an extended period... as long as the liquidity trend is positive.

But there's one problem...

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How the CLI Will Track the Next Market Downturn

When the market finally starts down, I would expect it to correct at least to the 39-week moving average of the CLI, which is now at 2,200 (about 10% below where the S&P 500 is trading right now).

From there, it should begin rising slowly.

But that moving average will not continue to advance at its current rate once the Fed starts "normalizing" its balance sheet.

Liquidity is the key to generating profits on a monthly basis, and Lee Adler's here to help you find it. Twice each week, he updates Lee Adler's Sure Money readers on the flow of liquidity in the markets, plus his best strategies for staying ahead of the tide. To get Lee's research delivered directly to your own inbox, just click here. It's completely free.

As you know, "normalization" is a euphemism for draining funds from the banking system, reducing the size of the pool of cash available to drive prices of stocks.

Because of this Fed draining, the CLI will begin to flatten. The Fed has officially told us that when the normalization program starts, it will rise from an initial $10 billion a month in draining to $50 billion over the course of a year.

And as the amount of money coming out of the system goes up, the CLI will move lower.

That will be something new. Periods of shrinking macro liquidity are historically extremely rare. Long-term historical data for the components of the CLI don't go back far enough to show those rare periods prior to 2007.

But it does tell us what happened then - a massive bear market that included a crash in September-October 2008.

The current bull market has persisted for eight-and-a-half years, driven by massive increases in liquidity from central bank money printing. The ECB and BOJ will continue printing for a while longer, and some of that cash will flow to the United States, but Fed draining will counter that.

Most likely that draining will begin in October - a little more than a month from now.

We should not turn bearish just based on the market being overbought. But as with the LAMPP being on yellow and getting perilously close to red, the CLI is sending us a clear warning.

Today's market overextension represents an extreme level of risk. We don't want to overstay our welcome on the long side. Any sign of market weakness should be viewed seriously as a sign that the phase of the bull market where you could simply buy the dips and hold on through the pullbacks is over.

For now, you should avoid buying the dips and continue to follow a systematic program of selling to raise cash. You'll want to have a large cash cushion for when the market reverses to the downside because this time it will be for real.

I'll keep you posted on the LAMPP each week as we watch vigilantly for that all important red signal.

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The post Here's How I Know the "Red Light" Is Coming Soon appeared first on Lee Adler's Sure Money.

About the Author

Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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