What Is Liquidity?

The ongoing commentary in the market is that liquidity is driving up share prices rather than fundamentals. What exactly is liquidity?

Liquidity is not institutional flows, for sure. If anything, institutional flows lag share prices, and liquidity is mostly a coincident indicator. In practice, flows are always net zero, so looking at one side of a trade, such as what institutions are doing in the market, is flawed. Liquidity, in our view, is the relative force between the bid and the offer. If the bid is stronger than the offer, then liquidity is judged to be good, and share prices rise and vice versa. The source of liquidity is confidence in growth and macro stability. Where such confidence comes from is a mystery to market participants using reported data to understand share prices, as this confidence is about the future and not about trailing data. That said, reported data plays some role in shaping up confidence about the future.

The bottom line is liquidity (the strength of the bid) is rising when the confidence about the future is rising. When this confidence is too high, share prices get ripe for a concerted fall. Are we there? To answer this question, we need to first measure liquidity. We offer four metrics:

• the gap between the change in trailing price-to-earnings (P/E) and earnings,
• the gap between India’s earnings yield and the U.S. treasury yield,
• our proprietary financial conditions index, and
• the difference between the year-on-year change in share prices and the year-on-year change in cash, checking deposits, and near money (M2).

The logic for these indicators is inside this essay. Given the ephemeral nature of liquidity, none of these measures is watertight in its ability to depict liquidity fully. That said, they are currently not suggesting excesses that would point to a significant correction in Indian equities.

Liquidity ≠ Flows

Market participants conflate liquidity with flows, especially institutional flows. This implies that institutional flows are some form of divine intervention that drives share prices.

Secondly, institutional flows, if anything, lag share prices rather than lead them. To us, liquidity is the relative force between the bid and the offer that determines where the asset price goes.

Every buyer has a seller, so in practice, net flows are always zero, but we make the mistake of according greater importance to “smart” flows, such as institutional flows and report these as the net buying/selling in the market. Indeed, on aggregate, institutional flows are not so smart and, hence, are a contra-indicator. So when they get too high, we get worried that the market is getting exuberant, and vice versa. Thus, they are very useful in timing the market, especially when used in conjunction with other indicators, such as market breadth, volatility, and valuations. Therefore, flows are a sentiment indicator, as we have always treated them in our work.

On the other hand, liquidity is not a physical quantity like flows – it is ephemeral, like consciousness. We know it is there but struggle to measure it. That said, there are some proxies for, or more appropriately, manifestations of, liquidity.

Rate Of Change In Share Prices Versus Trailing Earnings

Share prices should rise with earnings; when they don’t, it is because the P/E ratio is changing. The P/E ratio change is attributed to confidence in future earnings. If this confidence is low, P/Es are falling, and vice versa. But what exactly is this confidence – it is what we call liquidity. So when share prices rise faster than earnings, liquidity is pouring into shares, i.e., the relative force of the bids exceeds that of the offers.

Earnings Yield Minus U.S. Treasuries Yield

We measure global liquidity with our proprietary modified earnings yield gap, which is the difference between the trailing earnings yield and the U.S. 10-year bond yield. The indicator’s rationale is that liquidity needs to vary with the level of share prices (i.e., valuations). Liquidity – or the bid – required to move stocks, is higher when share prices or valuations are higher.

Financial Conditions Index

Financial conditions can be defined as the current state of financial variables that influence economic behavior and thus the future state of the economy. The components for our proprietary Financial Conditions Index (FCI) include the price and valuations of the equity index, the short and long domestic treasury rates, the yield curve, commercial paper rates, the short-term credit spread, the Rupee and its valuation, and the change in money aggregate (M2). Rising asset prices will imply better financial conditions and vice versa. So this indicator does not predict asset prices but just tells us that they are rising, i.e., liquidity is good or falling (liquidity is tight).

Our proprietary FCI leads the Purchasing Managers’ Index for India by three months, which suggests that share prices – or generally speaking, asset prices – lead the economy rather than the other way around.

Sensex Year-On-Year Change Minus M2 Growth

Money supply affects prices in general and asset prices especially if it is in excess of what the economy needs. We find the gap between the performance of stocks and M2 growth as another useful indicator of the state of liquidity.

Conclusions: More Room

The following chart summarises where our indicators are and what to make out of them.

The bottom line is that liquidity looks in good shape and is not yet in excess territory for us to worry about the market’s medium-term trend.

Ridham Desai is managing director at Morgan Stanley India and also serves as head of equity research and India equity strategist.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.