VTI - IWM: Liquidity Factors Support The Bull's Continuation

2023-08-10 19:02:32 ET

Summary

• August is historically volatile, causing turbulence in the growth stock arena, but market liquidity remains plentiful.
• The growth-oriented iShares Russell 2000 ETF is undergoing a corrective pullback but is expected to resume its rising trend.
• Worries include a regional banking crisis, rising Treasury yields, and a recent U.S. credit downgrade, but liquidity levels support a bullish market.

August is historically one of the most volatile months of the entire year, which partly explains why the broad U.S. equity market is undergoing a small measure of turbulence lately-particularly in the growth stock arena. However, in spite of a growing number of worries on the economic and geopolitical fronts, market liquidity remains plentiful and should help the bulls maintain control of the dominant uptrend this summer, as we'll discuss here.

From the start of this year through July, the tech-heavy Nasdaq 100-Index (NDX) gained around 50%, as tech-oriented growth shares led the way higher for the broad market. It should come as no surprise, then, that the growth space has seen some of the biggest declines during the latest earnings season.

Indeed, the overstretched nature of the growth-oriented iShares Russell 2000 ETF ( IWM ) last month argued for a corrective pullback. Not surprisingly, the pullback so far this month has taken the growth stock index closer to the 50-day moving average as of this writing.

And while a close under the 50-day line is possible, I'm not expecting a major decline from here. I further anticipate IWM will resume its rising trend once the market's turbulence subsides. (See our previous commentary on the small-cap ETF, IWM: There's No Denying The Bull Now ).

That said, there are no shortage of worries out there for equity traders. For instance, talk of a growing regional banking crisis continues to build steam in some quarters after Kansas Heartland Tri-State Bank was closed by the FDIC a couple of weeks ago. Subsequently, a number of financial commentators took to the airwaves and the Internet to build a case that the ripple effect from this spring's regional bank failures has yet to be fully felt, or completely priced in, by the stock market.

Treasury prices, meanwhile, have also been in decline across the maturity spectrum recently, pushing yields higher-including a more than 50-basis point rise in the 10-year note-and prompting even more fear-laced news headlines across the media.

The recent U.S. credit downgrade by ratings agency Fitch (from AAA to AA+) was blamed for the latest Treasury market rout. It should be pointed out, however, that bond yields were already moving higher even before the downgrade, which suggests other factors are behind the bond rate increases.

There's no denying that rising Treasury yields are a potentially negative factor for stocks in the near term. After all, the last time the 10-year Treasury Note Yield Index was above the 40 level (below), there were elevated periods of equity market selling pressure in October and March. Therefore, stocks aren't out of the woods yet in terms of potentially negative spillover effects from rising yields.

But there are reasons for believing that the late summer volatility in equities will subside in the coming weeks and give way to a calmer, more buoyant trading environment as we head closer to the fall months. And one of the biggest reasons in support of this outcome are abundant levels of all-important liquidity.

You've likely heard the famous bromide that when it comes to stocks, it's all about "liquidity, liquidity, liquidity." That's another way of saying that if the money is plentiful while Wall Street's risk tolerance levels are high, a bull market is all but assured. (Indeed, it was against the backdrop of hyper-abundant liquidity that a lively bull market commenced in late 2022 and continues even now).

Echoing the theme of the market's abundant liquidity are, several key liquidity gauges that continue to show money still flowing, which in turn supports the bullish intermediate-term backdrop for stocks. Let's take a closer look at two of them.

High-yield bonds are subject to greater liquidity risks than other assets, so it typically pays to notice how "junk" bond prices and yields are behaving during an equity bull market. As it turns out, junk bond prices have been fairly buoyant of late, which is reflected to some extent in the chart of the SPDR Bloomberg High Yield Bond ETF (JNK).

JNK appears to be establishing a multi-month base from which additional gains could be made in the coming months. As for what might serve as a catalyst for such a rally, I would point out that there has been a huge spike in junk bond short-interest of late. According to a recent Bloomberg report, speculators have lately piled on with short positions against junk bonds to the tune of $7 billion-up 18% in the past month and the fastest pace since April.

Although the analysts Bloomberg interviewed believe the short bets could be troublesome for the high-yield debt market, if anything should occur to roil the bearish consensus and push JNK out of the upper boundary of its trading range (see chart above), then all that short interest could easily serve as fuel for a potentially spectacular short-covering rally. Moreover, an upside spike in JNK would certainly be a welcome sign for equities as it would suggest even more improvement in both the sentiment and liquidity backgrounds.

Now let's turn our attention to high-grade bonds. The iShares Investment Grade Corporate Bond ETF ( LQD ) illustrates the incipient optimism that has gradually emerging from the more conservative portion of the debt market spectrum. With Wall Street expecting the Fed to pause rate hikes going forward, the prospects for higher bond prices-and lower yields-is reflected in the tightening pattern visible in LQD and other high-grade corporate bond ETFs.

Finally, there's the testimony of Michael Shaoul and Timothy Brackett of Marketfield, who pointed out in a recent issue of Marketfield Asset Management's, The Weekly Speculator , that liquidity is still profuse. The two analysts noted that, due partly to the emergency injections into the regional banking system made last March by the Fed-but also because of "massive sums" pushed into the Fed's repo facility during 2020 and 2021-those funds are beginning to be drawn down and used to purchase a large amount of short-term Treasuries.

Shaoul and Brackett went on to explain that the Fed's recent Treasury purchases are acting as a counterbalance of sorts to the central bank's ongoing tightening cycle; otherwise, the stock market would likely be responding very bearishly to recent Fed rate hikes. In their words, this "effectively increases the liquidity provided by the Fed into the overall financial system."

All told, based on the factors we discussed here, the weight of evidence points to liquidity not being an issue right now. The financial sector has certainly taken the latest Fed rate hike in stride, with the NYSE Broker/Dealer Index ((XBD)) recently closing at a yearly high.

More importantly, however, is the testimony of the corporate bond market which so far has remained relatively unperturbed by unsettling news headlines and higher fed fund rates. With the liquidity factors discussed here still in play, equity investors should hold off on taking on additional risk in view of the recent volatility, but should also expect the storm clouds to dissipate as we head into the fall months.

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