Friday, July 13, 2007

Liquidity Driven Stock Rally

This Associated Press story captures the background of the irrational stock rally yesterday very well. While the conventional explanation of the rally was that it was due to Rio Tinto's bid for Alcan and the better than expected Wal Mart sales, that it is only the pretext for it. While it is certainly understandable that the stocks of Alcan and Wal Mart would rise, it makes no sense at all for other stocks to rise on these news. Why would stocks that aren't affected by the news rise in value? Why would for example Alcoa, who due to Rio Tinto's bid will lose the bidding war for Alcan or will be forced to pay an extremely high price in order to get it rise by 7%? And why would Motorola rise despite having issued an earnings warning?

And this trend of sharply rising stock prices despite mediocre news isn't just something that happened yesterday. Stocks have become much more expensive the latest year as they have increased more than 20% even though earnings are up only about 5%.

But as the story points out, what really drives the market is liquidity, which is to say rapid monetary expansion which at this stage mainly bids up asset prices. This is because the newly created money is generated by the debt creation that finances M & A activities. The M3 money supply measure is of course discontinued now, but if we look at the broadest still available money supply measure, the MZM (Money at Zero Maturity, which is M2 minus small time deposits plus institutional MMMF:s) it is increasing at a rate of more than 10% in America. As the article points out, what ignited the acceleration in monetary growth was the decision by the Fed last August to hold interest rates unchanged for the indefinite future.

The Fed, it seems, is again trying to re-inflate a new bubble.

UPDATE: Given that one of the pretexts used for the rally was stronger than expected sales at Wal Mart, one would have expected (assuming the pretext had any truth in it) stocks to sell off today when it was reported that overall retail sales were much weaker than expected. Yet stocks have in fact risen even further today. I rest my case....


Blogger Flavian said...

According to The Economist the average price of one Big Mac was $3,22 in January this year in July this price had risen to $3,41.

This seems to indicate that monetary policy in the US is very loose.

12:08 PM  

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