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Bond CEF Update: Liquidity Is Plentiful

Chart In Focus
April 24, 2014

Back in September 2013, I was calling attention to the liquidity problems to which bond-related closed end funds (CEFs) were alerting us.  The financial markets got over those liquidity problems, and now the message is that liquidity is very strong.  The stock market should be the ongoing beneficiary of that strong liquidity, for as long as it lasts. 

Bond CEFs remain the NYSE-listed issues with the bad reputation for supposedly contaminating the Advance-Decline data.  A lot of analysts believe that one should only ever look at the A-D data for "operating companies", i.e. real companies with real earnings, companies that do real things in the economy and not artificial instruments that are representations of financial engineering more than economic might.

The problems with this thinking are two-fold.  First, where does one draw the line?  Is GE an "operating" company, or is it really a mutual fund, with multiple operating entities?  What about Danaher, a conglomerate with multiple operating divisions?

The second problem is more functional; Bond CEFs as a group are just a great "liquidometer", acting healthy when liquidity is plentiful, and showing signs of trouble before it starts affecting other types of assets.  In 2007, the Bond CEF A-D Line topped well ahead of prices, and even ahead of the "common only" and composite A-D Line versions.  And in 2009 they showed resurgent strength ahead of the upturn in the major averages.  So if anything, the Bond CEFs are actually improving the message of the composite A-D Line by their inclusion in it. 

In the summer of 2013, the Bond CEF A-D Line was saying that there were big liquidity problems, and that was a message being repeated by a lot of other indicators I watch.  But the Federal Reserved kept up its "quantitative easing" (QE) program at a rate of $85 billion a month, and they seem to have papered over the liquidity problems. 

Right now, the Bond CEF A-D Line is acting stronger than ever, as the plentiful liquidity is flowing everywhere and bidding up prices on everything, even the less deserving closed end bond funds.  This is a condition which typically lasts until after there is a divergence evident, with the Bond CEF A-D Line turning downward ahead of stock prices.  For now, there is no sign yet of any such weakness, and so the message is that the bulls are in charge, with a tailwind of liquidity at their backs.  We will worry about what a future divergence means once one appears. 

Tom McClellan
Editor, The McClellan Market Report

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