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Chart In Focus

Bond CEFs Now Saying Liquidity Is In Trouble

Chart In Focus
April 05, 2013

Shortly after the Flash Crash in 2010, I wrote a Chart In Focus article explaining that the problems that the stock market had just been through in the wake of the Flash Crash were not liquidity problems.  I cited as evidence then that we were still seeing strength in the Advance-Decline (A-D) Line for bond-related closed end funds (CEFs) traded on the NYSE.  We are seeing a different situation now, which is worthy of mention, but first we should review the terms I am using.

Only about 60% of the issues traded on the NYSE are real "common" stocks, things we would think of as the shares of real operating companies.  But they generally trade about 90-95% of the share volume every day.

The other types of NYSE issues are made up of preferred stocks (18%), foreign issues (11%), specialty issues (13%, including rights, warrants, and structured products), and bond CEFs (8%).  Of these, bond CEFs are the ones most often blamed for "contaminating" the A-D data of the overall NYSE, and so a lot of technicians prefer to use some purified version of A-D data to avoid that contamination.

I take the opposite view.  If anything, the bond CEFs improve the composite A-D data by virtue of their presence.  The reason for this is that the main virtue of A-D data is as an indicator of market liquidity.  It is possible to push the major large-cap indices higher during an illiquid period if the limited liquidity is channeled into the "right" stocks.  But to get the large majority of stocks to go up, there needs to be such prolific liquidity that there is enough to go around for everybody. 

When liquidity starts to dry up, the least deserving issues tend to get culled first from the herd.  That is what we are seeing now in the bond CEF A-D Line.  These liquidity-sensitive issues have already turned downward as a group, even though the SP500 was able to continue higher.  This is a message that there are now liquidity problems facing the market, even though the Fed is continuing to drop money from helicopters every month.  Perhaps $85 billion a month is just not enough. 

The 2007 example in this next chart helps us to understand why this warning sign is so important.  The bond CEF A-D Line peaked back in May 2007, even ahead of the overall A-D Line which peaked in June 2007, and ahead  of the final market price high in October 2007. 

Bond CEF A-D Line 2007-13

The larger point is that these issues are more liquidity sensitive than others.  So if we see them suffering as a group, then the message is there is a liquidity problem which will likely come around to bite the rest of the market.  And when the market sees a meaningful dip for the SP500 without the bond CEFs getting hurt, the message is that it is likely a problem other than liquidity, e.g. geopolitics, investor mood, etc.  Those are easier problems for the market to get through than liquidity problems, which take longer to solve.

There is one notable anomaly in the middle of the chart which is worthy of mention.  Back in 2010, the impending end of the "Build America" bond program caused a lot of municipalities to rush some muni-bond issuances to market and take advantage of the free money from Uncle Sam.  That glut of new issuances then was more than the bond market could easily absorb, and so a lot of muni-bond prices fell as a result which took down the prices of some of the bond CEFs.  So that was an example of when the bond CEF A-D Line was "wrong" about an overall market liquidity problem.  We don't face a similar anomaly now.

It is hard to get one's mind around the idea that the stock market could be facing a liquidity problem when the Fed is throwing $85 billion a month at the banking system.  But that is the message here, from examining the actual behavior of those issues who are most sensitive to it. 


Tom McClellan
Editor, The McClellan Market Report

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