by Frank Shostak, Silver Seek:
The increase in the US stock market this year appears to defy the visible softening in the momentum of various economic data…
After closing at 735 in February 2009 the S&P500 has been following a relentless up-trend closing at the end of June this year at 2941.76 – an increase of 300% since February 2009.
The increase in the US stock market this year appears to defy the visible softening in the momentum of various economic data. For instance, there has been a deterioration in the annual growth rate of industrial production and a slowdown in the yearly growth of personal income (see chart).
In addition, the various manufacturing indicators such as the Dallas Federal Reserve bank and the Chicago PMI display subdued performance (see charts). Note that the Chicago PMI fell to 49.7 in June from 54.2 in May and 63.8 in June last year.
It would appear that the stock market has a life of its own and does things that supposedly appear in contradiction to the so-called economic fundamentals. But, a major factor that can explain the apparent contradiction between so-called fundamentals and the stock market is changes in monetary liquidity.
The Meaning of Monetary Liquidity
In a market economy, a major service that money provides is that of the medium of exchange. Producers exchange their goods for money and then exchange money for other goods. As production of goods and services increases, this results in a greater demand for the services of the medium of exchange (the service that money provides). Conversely, as economic activity slows down the demand for the services of money also slows down.
The demand for the services of the medium of exchange is also affected by changes in prices. An increase in the prices of goods and services leads to an increase in the demand for the medium of exchange. People now demand more money to facilitate more expensive goods and services. A fall in the prices of goods and services results in a decline in the demand for the medium of exchange.
Now, take the example where an increase in the supply of money for a given state of economic activity has taken place. Since we did not have here a change in the demand for the services of the medium of exchange this means that people now have a surplus of money or an increase in monetary liquidity.
As a rule, no individual wants to hold more money than is required. An individual can get rid of surplus cash by exchanging the money for goods. Individuals as a group however cannot get rid of the surplus of money just like that. They can only shift money from one individual to another individual. The mechanism that removes the surplus of cash is the increase in the prices of goods.
Once individuals start to employ the surplus cash in acquiring goods this pushes goods prices higher. As a result, the demand for the services of money increases. (Remember higher prices leads to the increase in the demand for money). All this in turn works towards the elimination of the monetary surplus.
Once money enters a particular market, this means that more money is now paid for a product in that market. Alternatively, we can say that the price of a good in this market has now gone up. (Remember a price is the number of dollars per unit of something). Note that what has triggered increases in the prices of goods in various markets is the increase in the monetary surplus or monetary liquidity in response to the increase in the money supply.
While increases in the money supply result in a monetary surplus, a fall in the money supply for a given level of economic activity leads to a monetary deficit. Individuals still demand the same amount of the services from the medium of exchange. To accommodate this they will start selling goods, thus pushing their prices down. At lower prices, the demand for the services of the medium of exchange declines and this in turn works towards the elimination of the monetary deficit.
From what was said so far we can infer that a change in liquidity, can also take place in response to changes in economic activity and changes in prices.
For instance, an increase in liquidity can emerge for a given stock of money and a decline in economic activity. A fall in economic activity means that fewer goods are now produced. This means that less goods are going to be exchanged – implying a decline in the demand for the services of money – the services of the medium of exchange.
Once however, a surplus of money emerges it produces exactly the same outcome with respect to the prices of goods and services as the increase in money supply does i.e. pushes prices higher. An increase in prices in turn works towards the elimination of the surplus of money – the elimination of monetary liquidity.
Conversely, an increase in economic activity while the stock of money remains unchanged produces a monetary deficit. This in turn sets in motion the selling of goods thereby depressing their prices. The fall in prices in turn works towards the elimination of the monetary deficit.
We can establish that monetary liquidity can be defined as,
Yearly percentage changes in AMS minus yearly percentage changes in the CPI and minus yearly percentage changes in industrial production.
It appears there is a time lag between changes in liquidity and changes in asset prices such as the prices of stocks. The reason for the lag is because when money is injected it does not affect all individuals and hence all markets instantly. There are earlier and later recipients of money.
The effect of previously rising liquidity on the stock market can continue to overshadow the effect of the present declining liquidity for some period. Hence, the time lag between the peak in liquidity and the peak in the stock market.
Likewise, the effect of previously declining liquidity can continue to overshadow the effect of current rising liquidity for some period. As a result, there is going to be a time lag between the trough in liquidity and the trough in the stock market.
How Changes in Liquidity Have Historically Driven the Stock Market
For instance, the yearly growth rate of liquidity topped in November 1927 at 10.2% – after a time lag of 22 months the S&P500 responded by peaking in August 1929 at 31.71.