The Role of Fundamentals in Sustaining Market Stability

The Role of Fundamentals in Sustaining Market Stability

Can the market exist for an extended period in isolation from fundamentals? No.

Understanding Fundamentals

But what are "fundamentals"? From 2017 through 2019, the average annual net inflows into U.S. household stocks and mutual funds will be between $350 billion and $400 billion, according to the Fed's calculations. From 2010 through 2016, it was about $250 billion.

From April 2020 through December 2021, the annual average rose from $1.4 trillion to $1.5 trillion (at least 3.5 times the norm) - about the amount needed to generate a bubble of this magnitude.

From the time of tightening (March 2022) through Q3 2023 inclusive (more recent data not available), net inflows have been close to zero on an accrual basis (strong outflows in 2022 and moderate inflows in 2023).

Sources of Liquidity

Current market levels are consistent with the need to absorb at least $3 trillion per year (realistically closer to $4 trillion) to keep the bubble from expanding. Sources of liquidity include dividends, buybacks, flows from households, and purchases from non-residents or QE liquidity.

In 2021, it is estimated that about $2.9 trillion was injected into the market to expand to 4,800 points. About $1.5 trillion came from businesses, the rest was taken up by U.S. households ($1.6 trillion) and non-residents - about $400 billion. Other entities acted as sellers for $600 billion (mainly pension and insurance funds).

Household Savings and Market Capitalization

The main resource is the savings of households, formed at the expense of the balance of current income and expenditures. Thus, now all household savings relative to market capitalization have collapsed to 1.5%.

The net current liquidity accumulation capacity in the equity market is at its lowest level ever. This means either QE of up to $3 trillion a year or the market will collapse by a third under its weight with no resources to intercept (non-residents and all other entities are sellers).

Conclusion

Thus, the market cannot sustain itself without taking into account fundamental factors. Recent data shows a sharp increase in liquidity injections, which is necessary to maintain current market levels. However, stagnant net inflows and reduced accumulated liquidity pose a significant risk. This underscores the importance of fundamentals for market stability and the need for proactive measures to address the looming liquidity crisis.

Table of contents
  1. Understanding Fundamentals
  2. Historical Trends in Market Liquidity
  3. Sources of Liquidity
  4. Household Savings and Market Capitalization
  5. Conclusion