Chart 1 maps out the S&P; 500 with money velocity (GDP/M1 ratio). There is a 90% correlation between the two. It is one thing to have the Fed pump liquidity into the system but it is quite another for the liquidity to be re-leveraged into credit and recycled into the economy.
The Fed’s easing program is over two years old and the rampant Fed balance sheet expansion 15 months old, and still to this day, what the commercial banks have done (to Obama’s wrath) with all that liquidity is to keep it as cash on their balance sheet to the tune of $1.2 trillion. We’re not sure why Obama is as rankled as he is because the banks are in fact lending out a good chunk of that Fed-induced liquidity — right back to Uncle Sam (the banks now own a record $1.3 trillion of government securities).
Back to the chart — there is obviously a close connection between money turnover and the stock market. But we can get periodic divergences as we did in the first leg of the rally in 2003. But the carry-through from 2004 to 2007 hinged critically on that multi-year acceleration in money velocity. If we don’t see the banks begin to extend credit in 2010, it is hard to see the 2009 bounce from oversold lows as being sustained in the coming year.
David Rosenberg
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