One way of measuring the amount of liquidity being injected or drained from the system is to observe the performance of the three financial markets: bonds, stocks and commodities. Calculating an 18-month rate of change for each, then combining them into one composite indicator and smoothing the result with a 6-month MA returns our Financial Velocity Index. A rising Index means that sufficient liquidity is being pumped into the system to be consistent with rising stock prices and vice versa.
We can improve this approach by introducing a similar momentum indicator for GDP and subtracting it from the raw financial velocity number. GDP is reported quarterly and financial market data is available monthly. Therefore, the GDP series has been modified from a quarterly series to a monthly one, where each individual quarter’s number is plotted for three consecutive months.
How It Works – a Typical Cycle
We can think of the financial velocity indicator as a proxy for the injection or draining of liquidity, and GDP growth as the economic bi-product. At the beginning of the cycle, the economy is in recession or slowdown mode. That means the central bank injects liquidity into the system. This causes interest rates to fall and bond prices, one of the ingredients of the Velocity Index, to rise. When the stock market senses that economic conditions will improve as a result of easy money, the trend of declining momentum reverses and two components now rally. Since GDP, which is a coincident indicator, is still falling, that’s usually enough to reverse the financial velocity series and trigger a buy signal. As time marches on, commodity momentum, if it hasn’t already, also bottoms. Eventually business conditions improve to the point where commodity prices begin to adversely affect bond price momentum through rising interest rates. The financial velocity series is still able to rally, because rising stock and commodity momentum outweigh peaking action in bonds. Equity momentum eventually tops out as stock market participants begin to anticipate that rising rates will adversely affect the economy and corporate profits. On the one hand, forward looking financial market velocity is slowing. On the other, the coincident GDP momentum is picking up. This sets the scene for a peak in the financial velocity GDP indicator.
The Financial Velocity/GDP series has been plotted in Charts 1-4. Charts 1 and 2 use the red vertical lines to flag sell signals from a primary trend or business cycle point of view. False negatives are represented by the dashed lines. Even some of these were followed by an intermediate decline or extended price consolidation of some kind.
The indicator can certainly be criticized for the occasional false signal or for being unduly early, such as the 1972 sell signal. By and large though, it has been pretty reliable in calling primary trend turning points, especially at cyclical bottoms.
Chart 1 — S&P Composite versus Financial Velocity/GDP 1898 – 1957 Sell Signals
Chart 2 — S&P Composite versus Financial Velocity/GDP 1955 – 2020 Sell Signals
Chart 3 — S&P Composite versus Financial Velocity/GDP 1899 – 1958 Buy Signals
Chart 4 — S&P Composite versus Financial Velocity/GDP 1957 – 2020 Buy Signals
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