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Question: "What does a bathtub and the economy have in common? "

Answer: "They are both totally dysfunctional without liquidity. "

Very simply, a tub needs water and a modern economy needs financial liquidity in order to operate.

During the early stages of Paul Volcker's war on inflation, I attended a presentation by an insightful investment advisor who used the analogy of a bathtub to link the economy's liquidity to the performance of investments and specifically, the stock market. The following discussion is based on a revised version of his model. Like a political cartoon, the model is grossly exaggerated and oversimplified. Nonetheless, it a useful tool in coming to grips with major issues confronting stock markets.

The model quickly comes together when the basic components of a bathtub are associated with key elements of the economy and its markets.

The Tap is representative of a central bank. Just as a tap controls the flow of water into a tub, a central bank is the primal source of financial liquidity to its economy. Altering monetary policy is the equivalent to adjusting the flow of water from the tap.

The Drain is symbolic of the flow of funds drawn into the real economy. However, unlike tub water going into the sewer, monetary flows fund the many aspects of a dynamic economy. Ideally of course, this leads to growth, wealth creation and an overall increase in a nation's living standards.

The Spa Jets symbolize the impact private banking activity has on economic activity. Economists refer to this as the "multiplier effect," whereby money is re-circulated through the economy as funds are deposited and then re-loaned by the private banking system. As confidence and activity grows in the real economy, the spa effect becomes more and more pronounced.

The Water Level in the tub corresponds to the net surplus funds (i.e., not being pulled into the real economy) available to investment markets. The dynamic interaction of the above three factors, determines the water level.

The Suds Volume symbolizes the state of investor expectations. It too is reliant, to varying degrees, on all of the preceding components. Excessive expectations result in suds overflowing the top of the tub whereas low points are nothing more than a soap scum on the water's surface.

At the model's optimum, each of its components is in balance and collectively they reinforce one another. Central bank policy is attuned to the needs of the real economy - i.e. accommodating solid growth while limiting inflation to a modest rate. The real economy's vigorous growth is generating productive credit demand. The banking industry is operating efficiently and prudently. Accordingly, the spa jets are injecting additional liquidity into the system. This means that the flow of funds available for investment markets is at a very comfortable level. Finally, the suds of investor expectations are impressive, but not anywhere near excessive levels.

This of course is the economic Utopia that policy makers dream of. Amazingly , this idyllic balancing act has actually come together many times in the past. However, because of the multitude of moving parts, not the least of which being human behavior, it is extremely difficult to sustain for any extended period.

Unfortunately, the bathtub model does not in itself provide mystical insights into the current economic environment or the outlook for investment markets. All it offers is a user friendly way to interpret economic issues and thus form a perspective on stock market valuations.

For example, here is my review of the US economy, as it has unfolded since the 2008 financial crisis.

Collectively, consumers, businesses and governments are the generators of liquidity demand in the real economy. The bursting of the housing bubble in 2008, decimated US consumer spending. Businesses reacted by slashing costs, most notably jobs; and the federal government while initially injecting massive stimulus, subsequently devolved into partisan gridlock. The resulting budgetary cuts are now also constraining growth. While there has been a steady overall recovery, unemployment remains high and credit demand is subdued. Consumers have focused on reducing debt and businesses remain decidedly cautious. As a result, the tub's drain is not exactly gushing and the liquidity spa jets are operating at sub-optimal levels.

From the outset of the crisis, the Federal Reserve's monetary tap has been wide open. Indeed the Fed's managed rates were quickly reduced to all-time lows. This maxed out traditional policy tools, making them ineffective. To create still additional fund flows, a second tap called "quantitative easing" was installed. All in, the resultant liquidity flowing into the economic tub has been torrential.

Although the tub's water level (liquidity available to markets) is high, it is because of the Fed's ultra-accommodative initiatives; spa jets have contributed comparatively little.

Finally, the suds of investor expectations are clearly evident. Not only has the S&P 500 Composite Index recovered entirely from the calamitous 2008/2009 market collapse, but has gone on to register a series of new all-time highs. There is one qualification however, volatility has been hypersensitive with many abrupt pullbacks.


Stock Market Volatility to Persist

In my view, stock markets are likely to remain volatile. The suds of investors' expectations are floating atop high levels of liquidity created at the central bank tap. This will continue to be the case until the real economy demonstrates an ability to sustain itself and generate above average growth. While the high liquidity available to markets is an enormous positive, it exists solely at the pleasure of the Federal Reserve. Investors are desperately looking for evidence that the economy has finally found its legs and will begin generating its own liquidity. Accordingly, market activity is being driven by the news event of the day (positive or negative), regardless of its longer-term relevance. My sense is that high volatility will continue to be with us for the next several quarters.

To successfully cope in this environment, my suggestion is to: "Keep Calm and use Volatility to Your Advantage." The simplest way of doing this is the tried and proven strategy of dollar cost averaging. By investing a preset amount at regularly intervals into your portfolio, you automatically buy more shares or fund units when prices get clipped. It takes the angst out of buying when market sentiment is unduly negative. Similarly, enrolling your stock and fund positions in dividend reinvestment programs, also serves to turn volatility into your friend.

Transitional Bear Market

Ironically, at the point when it is clear that the real economy has finally got its act together, it will also mark the beginning of what I refer to as a "transitional bear market". By definition, interest rates will then be on the rise - consumers, businesses and governments will all require more funds while at the same time, the Federal Reserve will be tightening its liquidity tap. Indeed, because of the time lags in implementing monetary policy, the Fed will likely begin cutting back well before the economy is judged to be totally road worthy. The sheer magnitude of the process itself is daunting. Just as the monetary measures taken to rescue/stabilize the economy were unprecedented, so too will the path back to a more normalized balance. I anticipate that this will impose a heavy toll on investor expectations. For example, as interest rates begin to rise, bond investors will fret that the Fed has responded too late and that hyper inflation is about to erupt. Alternatively, equity investors will be concerned that the Fed is acting too aggressively relative to a still rejuvenating economy. The overriding fear will be a return to recession or worse yet stagflation.

Of course, preparing for a bear market is more involved than dealing with interim volatility. The guiding principle here is to: "Keep Calm and Stay Disciplined". My definition of discipline involves, ensuring that my investments are, in fact, consistent with my longer-term objectives. That done, the priority for my stock portfolio is to avoid any forced liquidation at deeply discounted prices. Bear markets are generally defined as declines of 20% or greater. Since 1946, there have been thirteen such peak to trough collapses, ranging in length from 1.5 to 36.5 months [Source: Nick Murray, Simple Wealth Inevitable Wealth (The Nick Murray Company, Inc.) 2010]. Accordingly, in structuring your overall portfolio, I suggest that provision be made for possible liquidity needs during a bear market . I recommend that you consult with your financial planner, as to what the appropriate amount is for your situation. Whatever the amount, my view is that it should not be invested in stocks, but rather tucked away in a liquid money market fund. This will leave your equities undisturbed to wait out the pullback.

How deep and how long this transitional bear will take is all but impossible to predict. Much will depend upon timing, communications and the scale of unanticipated developments.

Prospects for a Major Secular Bull Market

Notwithstanding my views on interim volatility and the likelihood of a transitional bear market, I am an unqualified optimist regarding the longer-term prospects for economic growth and vibrant investment markets . Economic history is basically a recounting of the various stages of an ongoing cycle - growth, excesses, collapse and re-construction. I believe that we are nearing the end of the reconstruction phase and a period of renewed growth is about to unfold. US consumers have reduced their debt burdens, the business sector is well positioned to grow and make capital investments and the private banking system is again sound. Hopefully, at some point, political leadership will also escape its juggernaut. There are also bases for optimism internationally, be it in Europe or Asia.

In summary, the sludge that partially clogged the tub's economic liquidity drain has been removed and new spa jets are about to become operational.

This scenario cannot not be anything but positive for investment markets. Nevertheless, I believe that the guiding principal for bull markets is the same as bear markets: "Keep Calm and Stay Disciplined". Increasingly, as the new bull gets established and gains momentum, investor expectations will begin to bubble to the top of the tub. Therefore it is critical that we stay focused on a realistic set of investment objectives and respect our risk tolerances. Without a doubt, there will be future excesses, of various magnitudes. Our challenge will be to avoid them to the greatest extent possible, while still achieving our goals.

To conclude, the overwhelming good news is that with a refurbished tub the economy and the stock market will soon be operating far more efficiently.

Source: Bathtub Model: Connecting The Dots Between The Real Economy And The Stock Market