Dropping US Liquidity Signals an Equity Rout As Investors Turn to Cyclical Stocks

Ahead of the Federal Reserve starting its scheduled asset purchases wind down, already a US financial liquidity measure whose drop foretells the worst equity routs in two decades has begun sounding the alarm. 

Marshallian K measure indicates the possibility of worse equity rout

The signal is unclear, although it has previously provided meaningful signals. It’s the difference between the rates of increase in the money supply and the rate of growth in the gross domestic product, a metric known among economic experts as Marshallian K. Interestingly, for the first time in over a decade, the measure has turned negative. This indicates that GDP is increasing rapidly relative to the M2 account of the government. 

The shortfall is a result of expanding economy that is rapidly consuming the available government’s money. As a result, the deficit is problematic for markets during a period when excess liquidity appears to be underpinning rallies such as meme stocks and Bitcoin. 

Leuthold Group’s chief investment officer Doug Ramsey said, “Put another way, the recovering economy is now drinking from a punch bowl that the stock market once had all to itself.” Through the 90s, equities rose during negative Marshallian K reading, but the pattern since the 2008 crisis when the Fed was in crisis mode calls for caution.

Investors turn to cyclical stocks as rates increase 

Over the past week, investors have been biding on cyclical stocks, but it needs to be shown whether reflationary trade will be the path to take owing to the COVID-19 situation. Markets are in the doldrums of the early days of August, and Federal Reserve and critical numbers on retail sales could offer guidance for equities this week. 

Last week, major market indices were uneven, with S&P 500 and the Dow reaching new highs while the Nasdaq remained flat. However, there was a noticeable upward trend in cyclical industries, which benefit when the economy is predicted to grow. For example, on Friday, materials jumped 2.7%, with industrials increasing by 1.4%. On the other hand, financials that generally do well when high rates were up 1.9% as the tech sector, which underperforms with high rates, remained flat. 

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