Liquidity feeds bull for year-end

The end of the year has traditionally been associated by investors with a stock market rally. While the month of October had been a nervous one for investors, stock markets around the world appear to have regained their poise and look ready to deliver some festive cheer to investors.

With a few trading days left, November has so far proven to be a good month for stocks, reversing the losses in the previous month and leaving most of the major stock indices at or near their year highs.

	Close on 31 Oct	Close on 25 Nov	Percent change
S&P 500	1,207.01	1,268.25	5.1
Nikkei 225	13,606.50	14,784.29	8.7
FTSE 100	5,317.3	5,523.8	3.9
DAX	4,929.07	5,194.27	5.4
CAC 40	4,436.45	4,600.48	3.7
Hang Seng	14,386.37	15,081.47	4.8
Straits Times	2,216.77	2,295.73	3.6

The gains in November also mean that the global equity bull market remains intact. And this, in itself, is quite a remarkable fact.

With the collapse of stock prices from 2000 after the equity bubble of the late 1990s, many analysts had expected a prolonged secular bear market interrupted periodically by short rallies. However, although most of the major indices have not regained their 2000 peaks, in terms of duration, the current bull market has now lasted around two and half to three years, pretty long for what is supposed to be just a cyclical rally in a longer-term bear market.

If this bull market has proven surprisingly resilient, an important factor must surely be ample liquidity. Despite all the noises made on rising inflation concerns of late, central banks have in fact not been particularly aggressive in tightening monetary policy. For example, despite well over a year of interest rate hikes, the Federal Reserve's target fed funds rate is currently at 4.0 percent, below the latest reported US annual inflation rate of 4.3 percent in October. And the European Central Bank has not raised interest rates for more than five years.

The resulting growth in global money supply was highlighted by Morgan Stanley economist Joachim Fels in a commentary in the Global Economic Forum on 8 November. In the commentary, he said that this year, global narrow money growth has outpaced global nominal GDP growth by 1.4 percentage points, broad money growth has outpaced GDP by 2.7 percentage points, and credit growth has outpaced GDP by 3.6 percentage points. Fels added that while the Federal Reserve's ongoing tightening campaign has led to a slight decline in excess liquidity in the US, there has been a significant increase in excess liquidity in the euro area.

All this liquidity, of course, is fuel, not just for the real economy but for asset markets as well. And Fels expects the excess liquidity to persist. "Aggressive central bank rate hikes to mop up excessive liquidity...are unlikely, in my view," he wrote. That leads him to think that "excess liquidity will likely stay around" and that "the next bubble could well occur in equities".

Other analysts, while expecting a short-term rally into the end of the year, are more cautious going into 2006. The view of Stephen Leeb, president of Leeb Capital Management and editor of The Complete Investor newsletter, expressed in an interview given to BusinessWeek Online on 17 November, is typical among these analysts. "Stocks are on an uptrend and will finish the year on highs," he said. "But past January, problems will surface. It will be hard to control inflation, and that's a hard environment for stocks."

Some analysts in Asia have similar views. In a report on 23 November, The Business Times cited Lee King Fuei of Schroders Investment Management as saying that "there are more headwinds to equities" partly because interest rates are "in a normalising process", but while rates are nearer to being neutral, "there is still some distance to go".

In the same report, Martin Lau, First State Investments director (Greater China equities), was quoted as saying: "Asian economies are very strong, but things will start to roll over in 2006 because of a higher base. Investors should be aware that things on the margin are slowing."

And there are indications that the US stock market may roll over in 2006 too. In a commentary on 21 November, John Hussman of the Hussman Funds pointed out that the current rally in the US market lacked breadth and is being led by low-quality stocks. "Historically, garbage stock rallies like this are a hallmark of the late, narrowing, impatient, speculative phase of a bull market," he said.

While Hussman's point raises concerns about how much longer the ongoing rally can last, it also highlights the impact that excess liquidity is having on the demand for equities. And that liquidity may mean that investors hoping for a year-end rally in equities might just get their wish fulfilled.