Stocks riding on a flood of liquidity: Risk is back on

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Nick Godt's Market Medics
Sept. 25, 2010, 12:07 p.m. EDT · Recommend (4) · Post:   

Stocks riding on a flood of liquidity: Risk is back onCommentary: With no recovery, global central banks jump to the rescue
By Nick Godt, MarketWatch

NEW YORK (MarketWatch) — It might sound counterintuitive after the rally in stocks so far in September, not to mention in complete contradiction of the prediction of many Wall Street analysts, but the market is not betting on a U.S.or even a global recovery, for that matter.

That might sound hard to believe given that the Dow Jones Industrial Average /quotes/comstock/10w!i:dji/delayed (DJIA 10,860, +197.84, +1.86%)  is up 8.4% so far this month, the tech-heavy Nasdaq Composite /quotes/comstock/10y!i:comp (COMP 2,381, +54.14, +2.33%)  is up 12.6%, and the S&P 500 index /quotes/comstock/21z!i1:in\x (SPX 1,149, +23.84, +2.12%) , the broad gauge of the market most used by investment professionals, is up 9.5%.

In normal circumstances, this would be the type of rally that signals investors are betting the “all clear” on stocks, given a bright outlook for economic growth and profits.

But with retail investors mostly absent from the market, as they have been for the past two years, investment powerhouses are again relying on the same old trick that helped power stocks in March 2009.

What the market is betting on is lots more liquidity coming its way.

Faced with increasing signs of economic weakness, central banks in the U.S., Japan, and the European Union are stopping plans to remove liquidity, signaling more liquidity is on the way, or already intervening.

That’s a blessing for stocks, commodities, and gold.

Given the macro-nature of the global financial and economic crisis, assets have been increasingly trading in lock-step, meaning either risk on-type of assets such as stocks and commodities when things look up, or risk-off assets such as bonds, when things look down.

Renewed central bank moves towards liquidity are a clear green light:

“This is very much a risk-on environment given the ample liquidity,” says Mary Nicola, currency strategist at BNP Paribas.

But that’s very far from the market signaling it expects the economy to recover.

This past week the Federal Reserve summed it up nicely when it said it was worried about deflation and that it stood ready to take more extraordinary measures to reflate the economy.

Other central bank moves are also tell-tale signs. Earlier this month, the Bank of Korea unexpectedly left interest rates on hold, even though its economy is improving.

The European Central Bank, meanwhile, left in place programs to help boost liquidity.

And then in the past week, the Bank of Japan conducted its first intervention to pressure the yen in six years, through an “unsterilized” intervention that added to global liquidity.

Nobody wants a strong currency anymore, with exports appearing to be the only way out of the slump, as is also becoming evident with the increased pressure on China to devalue its artificially low currency and the dollar hitting multi-year lows against many emerging-market currencies.

No wonder that gold, which acts as a safe-haven against depreciating currencies, especially the dollar, is hitting new highs.

But more broadly, for stocks, the all-clear signal is on until the Fed next meets in November. And if the economy and inflation continue to weaken in the meantime, it’s all the more reason to rally.