Water

“The water understands Civilization well; It wets my foot, but prettily, It chills my life, but wittily, It is not disconcerted It is not broken-hearted: Well used, it decketh joy, Adorneth, doubleth joy:”

– Water | Ralph Waldo Emerson (1867)

It’s been an outcome that has been vexing many market analysts and investment pundits for much of the spring.  The US economy had been showing signs of weakening going all the way back to last year.  Then the trade wars came and the threat of economic recession and/or higher inflation escalated dramatically.  In the months since, the potential cracks to the US economy are starting to build.  Yet the US stock market, whose success is directly dependent on the strong economic growth and low inflation that so many investors are increasingly worrying about, continues to steadily surge its way back toward new all-time highs.  What explains this apparent contradiction?  It is not disconcerted, it is not broken-hearted: it is the continued abundance of liquidity in financial markets.

Joy. Liquidity understands markets well.  It has been the primary driver of higher stock prices since the day Ben Bernanke sat with Scott Pelley on 60 Minutes on March 15, 2009 talking about “green shoots” for the US economy as the US Federal Reserve was launching the first of its many future rounds of Quantitative Easing, which is a fancy way of describing the injection of liquidity into financial markets.  How powerful was this steady flow of liquidity in the years that followed?  Despite a chronically sluggish economy mired by the persistent threat of deflation for more than a decade through the 2010s and into the 2020s that saw the net outflow of more than $1 trillion from domestic equity mutual funds and ETFs according to the Investment Company Institute along the way, the US stock market as measured by the S&P 500 increased by more than seven fold from below 700 in 2009 to nearly 5000 by the end of 2021.  Decketh-ing joy is an understatement.  When retail and institutional investors are selling US stocks by more than a trillion dollars on net and the US stock market can register a seven bagger higher over the same time period, that’s septupleth-ing joy at a time when stocks should otherwise be getting gutted.  That’s how powerful liquidity is to financial markets.

Still wetting our feet most prettily.  So where do we stand on the liquidity front today?  While we could scroll our way through a variety of more esoteric measurements demonstrating that financial market liquidity, while off of its recent all-time highs on a marginal basis from late last year on various metrics, is still running about as wide and deep as ever in aggregate.  But instead of getting into the weeds on this front, let’s instead turn our eyes to more commonly known or more easily accessible measures that show these same liquidity forces at work. 

First, consider US high yield corporate bond spreads, or the additional premium in yield required by investor to purchase a high yield corporate bond over a comparably dated US Treasury bond to compensate for the higher liquidity and credit default risk that comes with these riskier issuance.  We see in the chart below that the current spread of just 3.18% remains near the tightest spreads we have seen since the calming of the financial crisis at the start of the last decade.  What would cause these spreads to remain so tight despite concerns among many investors that an economic slowdown and/or higher inflation is looming around the corner?  An abundance of liquidity.

Let’s continue to another wittier measure of liquidity.  This comes from the chart showing the correlation of price performance between the NASDAQ 100 Index and the price of Bitcoin.  Why these two metrics?  Because the primary forces that would cause investors to continue to pay more and more and more and more for assets that are either trading in many cases with valuations more than two standard deviations above their historical mean (NASDAQ 100) or have skyrocketed from four-digits to six-digits in price despite having no store of value, unit of account, medium of exchange, or intrinsic value for that matter (Bitcoin – backed by the full faith and credit of . . . Um) are liquidity related.  Where do we stand on these two metrics?  Continuing from lower left to upper right for years as shown in the chart below.

In summary, financial market liquidity is an enormously powerful force, and the flow of this liquidity remains abundantly alive and well as we continue our way through 2025.

“Ill used, it will destroy, In perfect time and measure With a face of golden pleasure Elegantly destroy.”

– Water | Ralph Waldo Emerson (1867)

Elegantly destroy.  All of this talk about liquidity is fantastic.  But to a point.  It is important to remember that liquidity is a powerful force, but is one that can cut powerfully both ways.  While we remain awash in liquidity as we make our way through 2025, we did have a scary moment there in early April when financial market liquidity was suddenly drying up quickly with bid-ask spreads blowing out as retail and institutional investors were increasingly standing back amid the tariff announcement uncertainly until the 90-day pause was released (note that we are about 60 days into that 90 day pause right now – investment markets feelin’ alright like Joe Cocker in the meantime).

Let’s go further back in time, if you will, to even more profound examples where the evaporation of financial market liquidity had investors running for their financial lives.  This basically defined the 2022 bear market, as US policy makers had to quickly intervene and sop up much of the torrent of liquidity it had released into financial markets in 2020 in response to COVID because of the scorching inflation problem that it eventually started causing by 2021 and into 2022.

Let’s keep going.  The Great Financial Crisis?  All about the evaporation of liquidity as nobody wanted to buy those “AAA-rated” (chuckle) subprime mortgage bonds because they didn’t know what was inside of them (once again from the “if it’s too good to be true” files, if the market is willing to pay you 200 basis points in yield premium over US Treasuries for a comparably dated security that has the same credit rating, something is probably not right) and eventually by late 2008 everybody was trying to sell everything to save their bacon as the global financial system was being sucked down a virtual black hole vortex.

One more for the old timers out there.  The Great Depression in the 1930s was not because the stock market crashed in October 1929.  After all, you could have gotten out of the stock market with nearly all of your money still intact six months later in April 1930.  Instead, it was the response to the worsening economic situation in the wake of a decade in the roaring 1920s where a redonkulous amount of liquidity ran wildly amok had US policy makers trying to apply the solutions that fixed the 1920-21 depression from just a decade ago by stubbornly withdrawing liquidity as the economy was contracting and plunging into deflation (turns out about the exact opposite of what most reasonable policy makers (or politicians seeking to get reelected) want to do).  What was the thinking at the time?  Accelerate the cleansing of the excesses out of the economy in getting to a new bottom that would form the foundation of the next great growth phase.  Worked famously in the 1920s due to what in retrospect were unique circumstances.  As for the 1930s, not so much.  Keynesian shut out over the Austrians that continues to resonate to this day nearly a century later, and the score in the game basically all came down to liquidity.

Ill used, it will destroy. This will be an important key to monitor for financial markets as we continue through the rest of 2025 and beyond.  Liquidity well used by monetary policy makers at the US Federal Reserve and fiscal policy makers in the legislative and executive branches in Washington can help support a stock market to soar to new all-time highs even at times when arguably it shouldn’t otherwise.  But the key is the careful and measured application of this liquidity.  Too little, and the economy can descend toward recession pretty quickly if underlying conditions are weak.  Conversely, too much and the economy can quickly overheat, resulting in a spiraling inflation problem reminiscent of the 1970s or 2021-2022 more recently.  The latter liquidity evaporation is something that both stocks and bonds would recoil at just as they did throughout 2022.

For this reason, arguably the best thing the US legislative and executive branch can do going forward is to let US monetary policy makers do what they feel they need to do on the liquidity front to help make sure we maintain the right balance.  We’re already fast tracking back to new all-time highs, and the Fed has a ton of flexibility to lower interest rates if and when they need to (absolutely nobody is even talking about the Fed raising interest rates right now).  The strong case can be made to let the Fed keep their powder dry while giving the economy and markets a chance to breathe and potentially upside surprise in the months ahead, as these are the outcomes that are already taking place.  If the Fed does too much, too soon (see the market response following the September 2024 FOMC meeting – way too much, too soon from the prospective of this Chief Market Strategist), it could threaten to derail the positive momentum since mid-April.  Depending on how the budget debate resolves itself, some strong liquidity forces may soon be coming on the fiscal policy side anyway.

While many investment market participants continue to climb the stagflationary looming economic recession and renewed rise in inflation due to tariffs wall of worry, the good news is that economic growth remains solid, inflation expectations remain at cycle lows, and the underlying liquidity environment remains abundant.  These are all forces that support continued economic resilience and further stock market (and bond market too) gains in the months ahead.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Please consult a tax or legal professional for specific information and advice.

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