Liquidity Leads Stocks Lower

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Heere’s a question, does the stock market really lead the economy? Or does liquidity lead the stock market?

–If the stock market leads the economy, then why did positive jobs data in the U.S. lead to falling copper, oil, and gold prices late last week? We thought positive jobs data meant the U.S. economy was growing stronger than expected. And we expected, naively perhaps, that if the U.S. economy is chugging along, this is bullish for copper and most other commodities.

–But wait. The U.S. housing-market is in a gradual decline, we read. One of its largest mortgage lenders, Freddie Mac (NSYE:FRE), says it lost half a billion greenbacks in the third quarter as a result of falling interest rates, which it apparently did not figure in its interest rate hedging model.

–Not to worry! Even if the housing market is not growing, the economy appears to be. That means interest rates may be headed up in the U.S. which must be good news for Freddie!

–Ah, now we think we’re on to something. If the jobs data means a rate rise is in the cards for the U.S. markets, the seemingly-good economic news now is not the real story. When the Fed says, “rising interest rates” the stock market hears, “tightening liquidity.” And today, commodity prices have more to do with the ebbs and flows of global capital than they do with the underlying conditions in the real economy. Liquidity leads the stock market.

–What does this mean? We have no idea. But we’ll have a go:  for starters it means a bull market in the U.S. dollar for awhile. We outlined our thoughts on this after we went to press with Friday’s DR. You can find the short version at http://www.dailyreckoning.com.au/dollar-bull/2007/01/05/ The dollar looks to have bottomed out against other currencies, at least for awhile. And that means commodities priced in dollars will have to work harder in 2007. They won’t go up because the dollar is falling. If they go up, it will be because demand for them is rising.

–Where does that leave oil and gold? It’s presumed that gold and the dollar cannot rise together, but we’d expect to see exactly that this year. Gold typically rises as a hedge against inflation. And if the Fed does indeed raise rates, it’s because it fears inflation. Traders may sell gold positions when they see the dollar gain strength (and yield). But this just shows how short-sighted traders are. The stability in the gold price at $600 is a great chance to accumulate before the next big move.

–As for oil, we don’t have much to ad that we haven’t already said ad nauseam. The short-sighted focus on weekly inventories in the U.S. is just plaid stupid. Warmer temperatures in North America do not affect the demand for oil as transportation fuel. And that is the big driver behind petroleum prices, not heating oil prices in America’s North East. There may be some excess cash still sloshing around in the energy sector. But quality energy assets are still the buy of the century, whenever and wherever you can find them at a reasonable price.  We’ll be shopping over at Outstanding Investments.

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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