This Liquidity/Sentiment Indicator Shows Little Enthusiasm For This Rally

The market’s vicious October rally has been lifted on a rising tide of liquidity, with only a tepid rise in bullish attitudes leveraged to that.

The Equities/Cash Preference Index (ECPI) is a ratio of the S&P 500 to total cash-like (both demand and time) deposits in the US banking system. By measuring how much stock prices rise or fall relative to the total level of banking system liquidity, it helps us to identify when trader sentiment is overextended with or against the trend.

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The August selloff and retest resulted in both the S&P 500 and this ratio reaching long term trendlines (Technical analysis really is pretty simple). The furious rally in stock prices since then has been far less impressive on the ECPI, which remains well below its 52 week moving average. Depending on whether the indicator rises back above its 52 week moving average, it should give us some indication of whether the long term trend of rising equities preference is shifting.

The picture here tells us that the big rally this month has been built on the rising tide of liquidity in recent weeks rather than a sharp increase in enthusiasm for stocks. That cuts both ways. It leaves a lot of room for an additional rise in prices if sentiment does begin to become more bullish and traders decide to commit more of their cash to buying stocks.

But if the indicator rolls over below the 52 week and 104 week moving averages, it would support the thesis that the long term trend of sentiment is turning less positive toward stocks. In that case, rising banking system liquidity would have less and less impact on stock prices. Ultimately, stock prices might decouple completely from the liquidity trend, just as oil and other commodity prices have done in the past year.

Sentiment and liquidity go hand in hand and trader attitudes can and do change over time. Rising liquidity tends to foment increasingly bullish attitudes and behavior. That can cause liquidity to increase even faster as speculators and business increase the leverage ratio of their collateral. In other words they borrow more and buy more. That’s what credit bubbles are about.