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I get the feeling that many pundits are getting somewhat nervous about the prospects for equity markets. Well, if I was just looking at the recent behavior of the S&P 500 and Russell 2000, perhaps I would also be somewhat concerned. Based on outward appearances, it does look as if the S&P 500 & Co is somewhat overbought and due for a meaningful correction.

However, there is more to the stock market than a few indices. There are few, if any, financial markets that exist in isolation. That is, their movements are not affected by or affect other markets, and the stock market is no exception.

The advance of the S&P 500 over the last 6 months was merely a symptom of an underlying condition or theme. Some call it a risk on/risk off theme, others call it the inflation/deflation theme, and still others might refer it to as the carry or liquidity theme.

I refer to it as the liquidity theme. In essence, liquidity is the life blood of equity markets. During times of "expanding" liquidity, equity markets typically do very well. Now liquidity is a difficult thing to identify. There is no one "liquidity" index. However, we can gain an understanding of liquidity conditions by the behavior of other markets that also tend to do well during conditions of rising liquidity.

Let us look at three markets:

  1. Emerging market currencies,
  2. High yield corporate debt,
  3. Treasury breakevens

The chart below is the JPMorgan Asian Dollar Index (emerging Asian currencies against the USD). I believe that this is perhaps the kingpin to understanding global liquidity conditions because contractions in global liquidity tend to show up first in emerging market currencies. This index appears poised to break to the upside, which is quite a feat given the drama that has unfolded in the Middle East over the last month or so.

click to enlarge images

Another liquidity sensitive market is the high yield or junk grade bond market. I have been pleasantly surprised to see junk grade bonds resist the recent weakness we have observed in equities.

The last "market" is the US Treasury breakeven market. This is not really a market; rather it is simply the inflation premium attached to TIPS. The graph below is the US 10 year breakeven (the yield of the US 10 year less the yield of the US 10 year TIP). The index is clearly suggesting that inflationary expectations are rising. It is interesting to note that it is now trading at a multi-month high, which suggests long term out of character behavior.

So there we have it: Three big reasons why global liquidity is expanding, not contracting, and why investors should see any weakness in equities as a buying opportunity instead of a reason to sell. That is, the primary bull trend in equities is intact and the major market indices should be trading higher rather than lower 6 months from now.

Disclosure: I am long DIA, CEW.