Earnings, GDP growth, Fed policy, Fiscal stimulus… the peanut gallery is never at a loss as to what’s driving the big moves in markets.
Here’s the thing though, when you drill down to the nuts and bolts of it, there are really only 3 macro fundamentals that actually drive the market. And if you know what these three are and how to read them, you’ll be head and shoulders above the competition. You can then employ the proper macro strategies that align with the big trends and turning points in the market; make more on the way up and lose less on the way down…
In this article, we’re going to lay out what these three fundamentals are and how you can use them to make sure you’re on the right side of markets. They are:
- Supply & Demand
- Risk Cycle
The dictionary defines the word fundamental as, “a central or primary rule or principle on which something is based.”
If there’s one “central or primary rule” on which all fundamentals are based, it’s market liquidity. Liquidity is the Mac-Daddy of fundamental inputs. And not surprisingly, it’s the least known and understood.
Here’s one of the greatest of all time, Stanley Druckenmiller, on the importance of liquidity (emphasis mine):
Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.
So what is liquidity exactly?
In simple terms, liquidity is demand, which is the willingness of consumers to purchase goods and other assets. This demand is driven by the tightening and easing of credit.
What we usually think of as money (the stuff we use to buy things) is comprised of both hard cash + credit. The amount of hard cash in the system is relatively stable. But credit is extremely elastic because it can be created by any two willing parties. It’s this flexibility that makes it the main factor in driving liquidity/demand.
The majority of the credit, and therefore money, is created outside the traditional banking sector and government. Most are created between businesses and customers. When businesses purchase wholesale supplies on credit; money is created. When you open a Best Buy credit card to purchase that new flat-screen TV; money is created. And when you purchase stocks on margin from your broker; money is created.
The logic is simple. The more liquidity in the system, the more demand, which in turn pushes markets higher.
Which leads us to our next question: What are the largest levers that affect the amount of credit, money, and liquidity in the system?
The answer to that is interest rates. These are set by both central banks and the private market.
The primary rate set by central banks is the largest factor in determining the cost of money. And the cost of money in turn determines liquidity/demand in the system.
When the cost of money is low (low-interest rates) more demand is created in two ways:  it makes sense to exchange lower-yielding assets for riskier, higher-yielding ones, and  more people are willing to borrow and spend (money is created) because credit is cheaper.
From a practical standpoint, the easiest way to gauge the liquidity in the system, whether it’s improving or deteriorating, is through various measures of financial conditions.
Below are four examples, though this is hardly an exhaustive list.
There are numerous measures of financial conditions, each with its own pros and cons and relevant timeframes. But, in simple terms, we want to be buying risk when financial conditions are easing (high yield spreads are falling, Financial Stress is low and trending lower, Corporate yields aren’t rising too quickly, etc…) and paring back risk when financial conditions are tightening.
Supply and Demand.
Equity demand fluctuates according to the levels of cash + credit (money) in the system — there’s a strong corollary to liquidity. Since credit is easier to create than cash (any two willing parties can create credit out of thin air with an IOU), credit largely drives the amount of investable money in the system.
The supply side of financial assets is comprised not just of the total amount of shares or bonds in existence, which is what many people mistakenly believe. But rather, it’s the aggregate market value — the total dollar amount in existence at current market prices — that makes up supply.
The equity market has a flexible supply. If demand for stocks goes up then equity flows will drive up prices, increasing the total market cap thus creating more supply to equilibrate to demand. It’s a self-correcting system.
Historically, US corporate share issuance has rarely exceeded 2%. Over the last three and a half decades corporates have been reducing their share count through buybacks and M&A at an average annual rate of 2%.
While the number of shares available to trade has been steadily falling, the amount of money (cash+credit), has been steadily increasing.
Over the last 50 years, the money stock in the US has gone up at an average annual rate of 8% a year.
Over the last five decades, the supply of equity (available shares) has been dropping at an average rate of 1-2% a year while the total money stock has gone up at an average rate of 8% a year.
This mismatch of supply and demand gives us a structural supply deficit of approximately 9.5% a year. 9.5% also happens to be the average annual return of the S&P 500 over the last 50-years. That’s no coincidence, it’s just basic math. We have an inflationary financial system where the money stock is always increasing and the supply of equities tends to fall due to buybacks and M&A.
When companies begin reducing buybacks and raising their levels of equity issuance, we want to become more cautious, because they’re implicitly raising the amount of supply. And all else equal, that’s a negative input for stock prices.
The risk cycle refers to the level of risk-taking or leverage that’s in the system. Since markets are reflexive, the risk is actually highest when it’s perceived to be the lowest and vice-versa. The market becomes most fragile when investors are most leveraged. That leverage creates incredibly weak positioning which manifests itself in margin calls and forced selloff cascade when the trend turns.
To measure where we are in the risk cycle you just need to track broader market sentiment and positioning. Below are a few of the available tools to which you can do this, though it’s far from an exhaustive list as there are numerous freely available indicators to track investor sentiment and positioning.
Sentiment & Positioning
To sum up, the three fundamentals that really drive the market are liquidity, supply and demand, and the risk cycle.
You want to be bullish and buying when liquidity is ample, supply is being reduced due to buybacks and mergers, and investors are broadly bearish and not overleveraged risk assets. And vice-versa, when the conditions show the opposite.
If you track these three fundamentals and employ the correct macro strategies to effectively exploit the resulting trends, you’ll do well over time in markets.