What is Liquidity?

If there’s one “central or primary rule” on which all fundamentals are based, it’s market liquidity. Liquidity is the Mac-Daddy of fundamental inputs. And not surprisingly, it’s the least known and understood.

Here’s one of the greatest of all time, Stanley Druckenmiller, on the importance of liquidity (emphasis mine):

Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.

 

So what is liquidity exactly?

In simple terms, liquidity is demand, which is the willingness of consumers to purchase goods and other assets. This demand is driven by the tightening and easing of credit.

What we usually think of as money (the stuff we use to buy things) is comprised of both hard cash + credit. The amount of hard cash in the system is relatively stable. But credit is extremely elastic because it can be created by any two willing parties. It’s this flexibility that makes it the main factor in driving liquidity/demand.

The majority of credit, and therefore money, is created outside the traditional banking sector and government. Most are created between businesses and customers. When businesses purchase wholesale supplies on credit; money is created. When you open a Best Buy credit card to purchase that new flat-screen TV; money is created. And when you purchase stocks on margin from your broker; money is created.

The logic is simple. The more liquidity and credit in the system, the more demand, which in turn pushes markets higher.

 

What Effects Liquidity The Most?

The answer to that is interest rates. These are set by both central banks and the private market.

The primary rate set by central banks is the largest factor in determining the cost of money. And the cost of money in turn determines liquidity/demand in the system.

When the cost of money is low (low-interest rates) more demand is created in two ways: [1] it makes sense to exchange lower-yielding assets for riskier, higher-yielding ones, and [2] more people are willing to borrow and spend (money is created) because credit is cheaper.

This affects the stock market in two ways: [1] share prices rise as investors trade up to riskier assets and [2] companies’ total sales increase because of higher consumer demand caused by cheaper credit. Liquidity affects both the denominator (earnings) and numerator (price per share) in stock valuations as it drives markets higher.

 

How Do You Measure Liquidity?

There is a myriad of ways to measure and monitor liquidity conditions.

No single method is best, but one of our favorites is using the Chicago Fed’s National Financial Conditions Index (NFCI).

This index combines over 105 different indicators of financial activity to form one easy-to-read liquidity measurement. Money markets, debt markets, equity markets, traditional banking systems, “shadow” banking systems — they’re all included.

The Chicago Fed also publishes the Adjusted National Financial Conditions Index (ANFCI).

Since financial liquidity conditions are highly correlated to economic conditions, this index isolates the uncorrelated component. It tells us what liquidity conditions are like relative to economic conditions.

Positive values indicate liquidity conditions are tighter than would be suggested by current economic conditions, while negative values indicate the opposite.

We prefer the ANFCI because it isolates liquidity conditions better than the NFCI.

The NFCI doesn’t always tell you when liquidity is deteriorating. In the late ’90s and 2014/2015, liquidity conditions were worsening but the strong stock market and strong economy kept the NFCI below 0, signaling liquidity was loose.

In contrast, the ANFCI was above 0 during the same period, signaling conditions were actually tightening.

The ANFCI is a little noisy to look at, but if you smooth the data with a 12-month MA, you get a nice picture of liquidity conditions in the U.S.

The cyclical nature of our economy becomes clear and it’s easy to see how liquidity predicts business cycles. You can use this tool to help you trade on the right side of the market.

 

Here’s the main point: When liquidity is tightening, take bearish trades. When liquidity is loosening, take bullish trades.

This index is also broken down further into 3 sub-indices — risk, credit, and leverage.

Risk is a coincident indicator, credit is a lagging indicator, and leverage is a leading indicator of financial stress.

For trading purposes, the leverage part of the equation matters the most to see where the stock market is headed.

Above-average leverage sows the seeds for a recession and a falling stock market. Below average leverage precedes economic booms and stock market rallies.

Ray Dalio discovered this logic long before the Chicago Fed and has made billions trading off it.

The leverage index can be broken down yet again to only include nonfinancial leverage.

Nonfinancial leverage is one of the most powerful leading indicators of stock market performance.

 

Why Is This Important?

Before making your next trade, take a look at these indicators.

How’s liquidity? Where are we at in the debt cycle?

Knowing these answers will make you a lot more confident in your trading. It’s hard to get blindsided by a big crash or miss out on a huge rally when you have a handle on liquidity.