A Bourse Diary

Thoughts on stocks, speculation and ... life

Saturday, November 19, 2005

Trend = Liquidity + Psychology

You know Andre Kostolany? His isn't that famous in the USA. Though, Kostolany was a great investor and - more importantly - has very strikingly described what I consider the central mechanism of the development on the stock exchanges. Symbolically it could be written down like this:

Trend (T) = Liquidity (L) + Psychology (P)

The main direction of the stock prices is determined by the monetary conditions (L) and the psychological attitude (P) of the investors (I call them "the public", because not only the directly involved and active stock-holders or investors are meant). A bull market emerges when both factors turn "positive", and there is a bear market if both factors are "negative". If factors are mixed (one positive, one negative) there is a flat or undetermined trend, possibly with a slight bias in the direction of the stronger one.

The market will go up if the public has a positive attitude towards stocks AND has enough (liquid) money to buy and vice versa. The "AND" is crucial: that's why e.g. on the top of a bull market, when sentiment is strongly positive, prices can stagnate regardless of the good news from the companies and the economy. The pace of the real growth and the investment activity, on the one side, absorbs much of the liquidity in the financial system. On the other, such development goes normally with higher inflationary pressure and hence increasing interest rates (on the money market - dominantly due to Central Bank (Fed) rate hikes - and on the capital market (longer durations) due to aversion to fixed income securities). The liquidity conditions turn "negative".

And vice versa: in the bottom of a bear market, when mainly bad news are coming from the economy, the business activity is low and there are no inflation concerns, the Central Bank can ease the monetary supply, the interest rates fall and the market is provided enough liquidity. It is ready for an upturn. When - suddenly - the sentiment of the public also changes, both factors turn positive, the stock market can explode upside. We saw something like this in 2003 - the long bear market and permanently bad news (from Enron and 9/11 to the Iraq tensions) have depressed sentiment (and prices) extremely although the monetary conditions (liquidity) were very stimulating. It was just a spark necessary and the market went up impressively although ca. 6-12 months afterwards the news from the economy still was negative.

From both, unfortunately, only the monetary conditions can be reliably observed. The attitude can change very suddenly, it is very instable and not foreseeable. There are only some indications for the sentiment of the public. Therefore the most crucial parameter for the stock market remains the liquidity situation.

Where do we stand now? The liquidity is narrowing as described in Where is the Threshold? posting, but still not a concern. Everyone seems to fear a cooling down of the economic activity, though this will free up liquidity from the real business and investments and also keep interest rates down. This will prepare the market for a strong up-move. I would expect, that if the economy growth pace decreases a bit, the stocks - astonishingly - will jump up!


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