Ebbing Liquidity Threatens to Leave Stocks High and Dry

Many observers believe liquidity has driven this year's gains and that a reversal could be telling.
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A cliche that often makes the rounds on Wall Street has a rising tide lifting all boats. What's often overlooked is what happens when the flow starts to ebb.

Even including their recent pullback -- the Nasdaq was off around 2% this morning, continuing a general retreat from this month's highs -- stocks this year have risen sharply, stumping a lot of people in the financial community. That the

S&P 500

, which began the year with its price-to-earnings ratio at a whopping 28, could tack on another 11% is surprising. That it could do so while the 30-year Treasury dropped more than 13% is positively dumbfounding. Struggling to figure out how this could have happened, a number of strategists and economists have come to the same conclusion: a flood of global liquidity.

"We hadn't been feeling too bright, having gone cautious on the U.S. stock market in February," explains Doug Cliggott, a strategist at

J.P. Morgan

. "What we felt compelled to do was explain why valuation methodologies are flashing yellow, if not red, and the market keeps on climbing. One fertile place for digging for an explanation was liquidity."

Through the first part of this year, liquidity was growing at a torrid pace. In April, narrow money -- the total stock of money in circulation and funds readily available for spending, called M-1 -- increased by 9.7% among

Organization for Economic Cooperation and Development

-member countries, according to


. It's been more than a decade since money's grown so quickly.

Now, however, Cliggott suspects the gains in narrow money will begin to shrink. Historically, gains in M-1 run counter to gains in industrial production. When industry is running full tilt, liquidity is typically approaching its nadir. When production finally turns around after an economic slowdown, liquidity levels are typically nearing their top. And this makes sense: When things are tough, central banks open up the taps; when they get a little too good, they tighten up the faucets, leaving less for the old punch bowl.

Quite Contrary
Industrial production and narrow money growth in the OECD

Source: Datastream, J.P. Morgan

Liquidity can have an outsized effect on markets. When money first floods the economy, it often cannot be immediately deployed in the real economy, and gets placed in financial assets instead. But when things are going strong, companies work hard to expand operations, making hay while the sun shines. That can draw money away from markets just as central banks are tightening.

This may be happening.

Morgan Stanley Dean Witter

chief economist Steve Roach has noted that globally, his firm has seen a significant reduction in financial-market liquidity across most asset classes. Roach thinks that an easing of liquidity may be a sign that the "interesting and almost unusual dichotomy" between the equity and bond markets may be over and that both markets may be more vulnerable to selling.

Still, even though there's been a lot of chatter about how liquidity may be slowing, people who watch money supply simply haven't seen it on a global level. "Money supply in the U.S. has slowed in the last few months," says Mickey Levy, chief economist at

Banc of America Securities

. "But I guess I don't buy the notion that liquidity is easing globally."

That may change soon. In Tokyo, there has been a change of tone in comments coming out of the

Bank of Japan

, a suggestion that someday -- not any day soon, but someday -- there will be a hike. At any rate, with Japan's key rate effectively at zero, money isn't likely to get easier. And in Europe, economic data have lately shown a pickup in the economy -- while central bank officials have lately been worrying aloud about too-quick money growth. If the force of global liquidity really has been one of the movers behind the gains in the stock market, things may get a little touchier.

"We're probably leaving the most supportive liquidity environment you can think of," says Cliggott, "and it can only get worse, rather than better, from here."