Imagine if you will, that the markets are a living, breathing entity. When a live being is fearful or feeling threatened, they protect themselves by seeking safety. Market participants do the same when there is uncertainty in the markets; they seek safety in bonds or precious metals. And when that same live being is no longer feeling threatened, they leave their safe haven, much like market participants do when the uncertainty subsides. When market fear has relaxed, cash will move out of bonds and precious metals, and into equities that benefit investors the most: The stock market.
In general, the market follows natural laws such as, geometric patterns and Fibonacci sequences, which is a result of human (trader) psychology. Trader psychology is why good traders follow chart patterns and/or things like the Fibonacci tool, with a certain amount of accuracy. Hence, when the market is fearful, traders might sell stocks and buy bonds or precious metals, and do the opposite when the fear is gone.
What are the pillars that create this flow? Historically, it’s supply & demand, which then drives price. But as markets no longer represent mercantile systems, the financialization has changed it to be heavily linked to the debt markets where lending is the primary influencer of price in equities.
There is always a known amount of cash in the system, and knowing what form that cash will take and where it will flow separates the average trader from the good traders.
We have a long history, before the late ’80s, where broad money was relatively constant and the simple relationship between bonds & precious metals and equities was a staple of fund managers. The market was predictable; If bond & precious metal buying was up, that meant stocks were falling, or at least soon to fall. The opposite was true if bond & precious metal buying was down; That meant stocks were rising.
This simple relationship isn’t as real in today’s market, because prime lending goals, fed policy, government regulation and interbank demand for reserves all play a role in where the money goes.
Roughly 40% of the economy is government spending, and not private sector activity. Central banks manipulating prime rates to near zero are meant to boost lending, which then increases money flow through the economy. The more a person or business can spend, in theory means the more the economy grows. When the FED expands banking reserves, further increasing credit, we can take advantage of knowing that cash will be used, in a low to negative rate environment, to buy assets and acquire high-yield debt’s.
Today, bond values can rise (which makes bond yields fall) with the market so long as the Fed balance sheet and liquidity to banks are expanding. How this capital moves from there is what is important, as cash always seeks the best asset class. An expanding Fed balance sheet means the Fed is buying bonds, and in turn, this pumps cash into the economy. That cash, as previously mentioned, will seek the best performing asset class, which is the stock market.
It’s an asset-based inflationary market today, designed to push the new capital into high growth assets. Even with the real economy not increasing in value, growing asset prices in equities can still inflate because of new money flow. The “new” money flow is simply the Fed pumping cash into the economy by purchasing bonds, which then drops rates, which then allows for “cheap” money. That is to say, companies and individuals can borrow money cheaper, at lower rates.
When this “cheap” money moves into the stock market and out of bonds , the bond rates begin to rise. This then gives the Fed room to buy more bonds, to keep rates from rising too much, which then pumps even more cash into the economy. And the cycle continues.
As a market bull, the basics are simple: If government spending is up, the bond to equity flow is positive. And chances are the dollar is either stable or slightly weakened… This all, in turn, bodes well for the stock market.
This year, post-COVID shock, we have seen this environment in the markets. Bonds have risen, causing yields to fall, and thus, the stock market rises. The yields falling has allowed for companies and individuals to borrow money cheaply. That “cheap” and “easy” money allows for company expansion, and allows for individuals to make more purchases.
The DXY valuation, although influenced by foreign markets, is another strong signal for market direction. It represents overall cash holdings gaining or losing, and is an intermediary between stocks and bonds. If the DXY is spiking it foretells a fast move out of stocks and potentially back into bonds/safe-havens. DXY can act as a fast signal whereas bond yields play out over longer time frames. If people are flocking to currency based “things”, the DXY will increase in value. The opposite is true if people are moving out of currency.
Keeping track of the overall picture of money flow can greatly help investors avoid holding on to the wrong side of a changing market.
Post written by Dumb Money Trader Kent, and edited by Dumb Money Trader.
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