Does the stock market have what it takes to reach -- and more importantly, sustain -- new all-time highs?
A detailed analysis of stock market liquidity sheds some light on this question.
How do you measure stock market liquidity?
We use the same liquidity gauge that foreshadowed the 1987, 2000 and 2007 market tops and virtually guaranteed that the 2010, 2011, 2012 and 2014 corrections would be followed by new all-time highs.
We can't reveal the true name of this gauge. For the purposes of this article we'll call this reliable liquidity measure "secret sauce." For more details, click on this Oct. 8, 2014 article.
Courtesy of a generous Federal Reserve, the stock market has been flush with cash since 2009, and that's been the status quo until now. But, for the first time since 2009, we are actually seeing credible evidence of liquidity shrinkage. How do we know?
Since 2009, there have been five corrections of more than 9%:(2010, 2011, 2012, 2014 and 2015. In 2010, 2011, 2012 and 2014, buyers rushed in and simply overwhelmed sellers.
How does the rally from the August 2015 panic low compare to the 2010, 2011, 2012 and 2014 comebacks?
A picture, or in this case a chart, says more than a thousand words. The chart below plots the S&P 500I:GSPC against our favorite liquidity indicator (secret sauce).
To compare the current rally with the previous rally we need a benchmark. The Oct. 23 S&P 500 recovery high will be our benchmark. Why Oct. 23? On that day, the S&P 500 recovered 78.6%, a Fibonacci number, of the prior losses.
We will now compare the strength of the current rally with the underlying strength of the 2010, 2011, 2012 and 2014 rallies at the 78.6% retracement benchmark.
This will help us discern how strong this rally is in comparison with the 2010, 2011, 2012 and 2014 rallies.
The left side of each blue box marks the precorrection high; the right side marks the S&P's 78.6% retracement level.
The ascending lines show that the buying pressure behind the 2010, 2011 and 2012 moves was actually much higher than price suggested. By the time the S&P retraced 78.6% of its prior losses, liquidity (secret sauce) recovered 119.75% to 193.47%.
Demand exceeded supply by a large margin, and stocks continued higher almost unabated.
The supply/demand picture changed in 2014. The internal strength behind the V-shaped recovery from the 2014 low was weaker than the S&P chart suggests. A table detailing each rally's internal strength is available here.
Although the S&P carried to new all-time highs, the advance turned choppy and eventually gave back most of its gains.
The rally from the 2015 panic low appears similar to the 2014 advance. That doesn't mean that the S&P 500 won't be able to reach new all-time highs, but liquidity analysis suggests stocks will have a hard time accelerating or holding on to gains.
Furthermore, secret sauce is still lagging behind the S&P 500. As this article points out, the same condition foreshadowed the 1987, 2000 and 2007 market tops.
<P/><em>This article is commentary by an independent contributor. At the time of publication, the author held put options on the S&P 500</em>