How to Watch the Money Flow

 |  Includes: DIA, QQQ, SPY
by: Mark Gomes

In response to my article, "Which Way Is the Market Going Next?", a few people asked if there's anything they can do themselves to determine the market's next probable move. Here are a few things you can do:

1) Follow the money. "The money" refers to government actions that either inject money / liquidity into the economy...or take it away. Money-in is generally a boost for the economy and therefore stocks. This can be a short- or long-term indicator, depending on the duration of the action and of course, the action itself.

For example, Alan Greenspan cut rates during the Internet bust until the economy (the stocks) started to rebound. He then KEPT rates fairly low for an extended period of time. When coupled with the favorable Bush tax cuts, the result was a 5-year bull market.

A example of a short-term action can be found in Graham Summer's excellent article, "Didn't Quantitative Easing End in March?". There, he shows that the Fed has consistently pumped money into the system during options expiration week. This is likely happening this week and so it's no surprise that the markets are up.

On the flip side, increases in sales tax, income tax, capital gains tax, etc all take money away from the economy. Money-out is generally bad news for the economy and therefore stocks. Waning stimulus funding is another current example of money-out. An aging inventory-replenishment cycle is another current example.

It's important to note that money doesn't have to be going out. To qualify as "money-out", there just need to be less money coming in. Less money coming in generally means less GDP growth. If the money flowing in becomes insignificant enough, GDP growth can become GDP shrinkage...and that's what a recession entails.

Obviously, it would be nice if we could always have "money-in", but that leads to speculative bubbles, as we experienced with the housing boom. The end results, as we've seen, are catastrophic. Thus, it's important for the powers-that-be to create the right balance between money-in and money-out.

So, where are we now?

Right now, we've probably got short-term money-in. It's options expiration week, so the Fed is probably feeding the system with dough. If that is indeed the case, next week we'll likely be back to money-out. This doesn't mean that stocks will go up for the rest of the week, nor that it will fall next week. However, it is an indication that this will be the case.

Beyond that, we've got intermediate-term money-out. Unemployment benefits have been blocked, taxes are slated to be increased, and the effectiveness of stimulus funding seems to have peaked. Overseas, China is cooling off, while Europe has moved from stimulus-friendly to austerity. This will be a force working against the market. In order for the market to rise, other factors will have to bear more weight. Strong Q2 earnings has done a good job for the past couple of weeks, but once most of the reports are in, something will have to take over. I struggle to ascertain what that might be. That leaves me bearish on the market for the next couple of months.

What happens longer-term will likely depend on how the global economy reacts to all of this money going out. To me, it seems most likely that the economy will slip in the wrong direction until the outcry for aid becomes too loud for the powers-that-be to ignore. Such an outcry usually walks hand-in-hand with a market correction. Therefore, that's exactly what I expect we'll see before more money starts flowing in.

Conclusions: The flow of money is one of many indicators I use, but it's a powerful one to learn. It has its roots in economic and politics, both of which are always good subjects upon which to educate yourself. I'll discuss some more indicators in my next article.

Disclosure: I hold long and short positions in the stock market