Saturday, January 16, 2016

The Liquidity Trap

I've had concerns about the stock market for a few years now. Sometimes, I wonder if I am a bear like David Stockman. Still, though, the fundamental values in a healthy stock market seem to have been violated for quite a while. In April of 2015, I wrote about slowing GDP in key bell-weather nations like China that would bring about a slide into Spring.   In July of 2015, I wrote about how previous indicators like the implosion of the Greece economy and significant drop in China's stock market seemed to indicate a spreading economic problem. Right now, stock prices are way down, oil prices are very low, and the threat of a deflationary spiral seems real. Interestingly, after teasing us with the threat of increased interest rates, the markets did not seem to react to their increase, but rather posted more reaction in response to significant problems in China.

Liquidity is a key to the health of the stock market. A symptom of poor liquidity and a lack of safe haven for short term cash has sovereign debt granting negative rates. In essence, investors are communicating they are willing to take a small hair cut (loss) just to keep their cash in a safe place. Interestingly enough, recent academic studies reveal that a lack of liquidity in the stock market foreshadows recession. (Chen, Chou, & Yen, 2016). Even back in September, the bond market was wallowing in illiquidity, and conditions are worse now.

As always in these situations, ill health in the bond market leads to problems in the stock market. (The opposite is true too). The part the commentators missed is the connection to low commodity prices. The price of oil is a significant part of this puzzle. Last March, several commentators thought Saudi Arabia was selling large quantities of oil to purchase military supplies. Other commentators thought the fire sale in oil was due to an expanding US oil industry. Anyway you argue this case, the result is a tailspin in oil prices. Oil is not the only commodity going down in price.

Another commodity that has diminishing value similar to oil is gold. Gold is coming down, which is odd when you consider that the stock market is going down as well.  Copper and most commodities, except for food, are retreating. Since so many commodities are going down in price, odds are good that demand for the raw materials is at a record low. Low demand is connected to economic problems due to demand's connection to Gross Domestic Product.

The above factors all tie into the Kondratiev (1998) theory of long wave economic cycles based on commodity prices (Gore, 2010). In between the technological waves, Kondratiev (1998) theorized a period of stagnation or depression.  

If we take these factors and postulate that the trends will continue, the future looks ugly with a recession on the horizon. A Krondratiev (1998) interregnum would be a bad place to go. However, the stock market is adjusted so rapid declines in value can not happen. We've seen the market blowing off excess valuation lately; hopefully this is a small correction. Additionally, the Fed can adjust our trajectory by using Quantitative Easing (QE). Never underestimate human ingenuity, we are truly masters of our destiny. Let's stay tuned for the next installment starting Monday.


Chen, S., Chou, Y., & Yen, C. (2016). Predicting US recessions with stock market illiquidity.                      B.E.Journal of Macroeconomics, 16(1), 93-123. doi:10.1515/bejm-2015-000

Gore, C. (2010). The global recession of 2009 in a long-term development perspective. Journal of International Development, 22, 714-738. doi:10.1002/jid.1725 

Kondratiev, N. D. (1998). In Makasheva N., Samuels W. and Barnett V. (Eds.), The works of Nikolai D. Kondratiev (S. Wilson Trans.). London, U.K.: Pickering & Chatto Limited.