When you have more savings or credit in an economy than there are productive places to invest them, that’s when you get a bubble. Too much money chasing too few good opportunities. The correct monetary policy in this situation is to take your medicine and tighten credit. Alan Greenspan, for the most part, has done the opposite in the U.S.
An example: Greenspan seemed to know, even in 1996, that he was looking at a bubble in the making. His monetary response, though, was not to contain it by tightening credit. Instead, he flooded the system with easy money. Part of this anticipated the Y2K problem, which never materialized. Y2K came and went. But Greenspan’s additional money in the system stayed, looking for a place to go.
If excess liquidity isn’t productive in an economic sense, it can still be a spectacle to watch. It creates its own bull markets, in stocks, real estate, and bonds, or in consumption (the symptom of which is a huge trade deficit). You get your basic asset inflation, rather than inflation in prices for goods and services.
The Dow Jones Wilshire 5000 (WLX) is an excellent measure of asset inflation because it includes all publicly traded, U.S.-headquartered stocks that trade on a major exchange. Though it’s called the Wilshire 5000, there are actually over 6,000 companies in the index. The level of the index is roughly equivalent to the total market capitalization of the U.S. stock market. That’s why WLX is often referred to as the “total market” index.
For example, at around 2,000, the Nasdaq is still down some 60% from its all-time closing high of 5,048 on March 10, 2000. All that liquidity has left tech stocks. But it has not left the market entirely, having partly moved into the WLX – which has moved from below the 8,000-mark to around 11,500 since 2003. So it has simply moved from one kind of equity to another, with additional liquidity going to real estate and the bond market.
Will what happened to the Nasdaq eventually happen to WLX, too? WLX fell nearly 50% from its March 2000 high to its 2002 low of 7,598. But at a recent level of 11,417, it’s not only up 50% from its low, but it’s also down only 22% from its all-time high. What does this tell us?
Most of the major theories of technical analysis (Dow Theory, the word of Gann, and Elliott Wave Theory) use the same vocabulary. The primary trend in the market is bearish. But the secondary trend — in this case, a retracement — has been a liquidity-driven rally in stocks since March 2003. Has the retracement rally reached its technical limits?
It all depends on two things: confidence and liquidity, both of which are intimately related. The Fed can reduce liquidity by raising rates. It’s been doing this piecemeal. But it’s highly unlikely to keep doing so if it notes a lack of confidence in the financial markets. The Fed knows that in a liquidity crisis, money stops looking for somewhere else to go. It simply vanishes altogether. Credit — and capital — are destroyed
By Dan Denning in Strategic Investment
Category: Economics