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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…
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.