A big change is coming: Liquidity is about to dry up in the global financial system
As liquidity dries up in the global financial system, investors need a wake-up call.
I have been running Stock Traders Daily, a proactive financial newsletter offering trading strategies, since the internet bubble in 1999, and I communicate with investors regularly. I’m hearing that investors do not respect the changes in liquidity that are coming.
The U.S.’s Federal Open Market Committee (FOMC) is taking steps to remove a massive amount of liquidity from the financial system for the first time in years. The European Central Bank (ECB) may announce similar moves next month.
Boy who cried wolf
It is hard to fault the average investor because they have heard repeatedly that the market may crash. It is almost like the boy who cried wolf; they have heard it so many times and it never happens, and now they don’t believe it will.
During the past five years of warnings from analysts, myself included at the beginning of the stimulus cycle, liquidity was being aggressively provided by central banks. The result: increased demand for global assets, including stocks, real estate and bonds. When liquidity is that strong and unyielding, it is difficult for any asset class to decline.
This brings us to a very important point: Artificially abundant liquidity is the driving force behind global asset rallies. Without central banks’ “help,” the S&P 500 Index SPX, +0.06% would not be anywhere close to being valued at 24 times earnings, where it is today. Historically, that multiple is 14.5.
The problem is, when liquidity is as ample as it has been, overvalued markets can get more overvalued. That is exactly what has happened over the past five years or so. The markets became more and more overvalued as liquidity injections from central banks came like clockwork.
Flow of money
The flow of money will be changing dramatically. The FOMC said Wednesday it would begin winding down its hoard of Treasury and mortgage-backed securities in October. The ECB’s policy board meets in October, at which time economists at Barclays, Deutsche Bank and Pictet, among others, expect the announcement of a tapering program.
The boy who cried wolf might finally be right. If liquidity is no longer as ample, it will be much more difficult for already overvalued markets to get more expensive. That could lead to material market declines, and the Nasdaq 100 NDX, -0.29% S&P 500, Dow Jones Industrial Average DJIA, +0.19% and Russell 2000 RUT, +0.35% could drop by about 45% without being undervalued based on historical multiples.