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Risk Canaries Remain Content

Have you ever wondered why there is a rose bush at the end of each row in a vineyard? No it is not make the vineyard look pretty, although it does bring color to otherwise bland looking rows of grapes. The reason is that roses are highly susceptible to disease perhaps more so than any other plant. So the idea is that if roses start turning up their leaves then you have at least some advanced warning to get to the grape vines before they start coughing! In the good old days coal miners used to take a canary into the mines because canaries had this unique ability to sniff out dangerous gases before humans noticed what relevance has this got to do with macro investing? Well just as gases in coal mines are toxic to miners, and black rot is fatal to grape vines so to are contractions in liquidity to stocks. What better way of studying the outlook for the stock market than by studying liquidity. How do we study "liquidity" well lets get practical, let the market tell us, specifically lets watch those instruments/securities/markets that are highly sensitive to changes in liquidity, much more so than your average "blue chip" stock. 

I use four indicators to give me an understanding of global liquidity conditions. 

  • Emerging market small caps
  • Junk grade corporate bonds
  • Commodities
  • Emerging market currencies
Why do these four markets work so well in forewarning of changes in global liquidity? OK let me answer it this way - how do canaries pick up the smell of toxic gases in coal mines well before humans do? Well quite frankly who really cares, they just do. In the same vain the fore mentioned indicators work and have a very respectable record of leading changes in the direction of major market equity indices.

Emerging Market Small Caps
T.Rowe Price High Yield (junk) Bond Mutual Fund

Proprietary Equally Weighted Index of 35 Commodities

WisdomTree Emerging Market Currency ETF
Is there any evidence of weakness in these "indicators of global liquidity". Well as they say beauty is in the eye of the beholder, I cannot see any weakness evident but of course you may see things that I cannot. Seeing (or hearing, smelling, feeling) is believing. I know it is difficult not to rationalize, to not have an answer for everything. It certainly doesn't seem too intelligent, but perhaps the only way of getting ahead in a game where everyone thinks they are intelligent or above average is to play it simple, not to rationalize and just go with the flow.

Disclosure: Long DIA