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The soil, the seed and the plant

While high liquidity may be the reason for the ongoing bull run, in the long term, liquidity alone can't take the market up

The soil, the seed and the plant

Equity markets are driven by liquidity. This is a somewhat fancy way of saying that unless there's a net amount of money flowing into the markets, stock prices in general will not go up. If this is true, then obviously, the converse is also true. When there is no net money coming into the markets, then they are stagnant and when there is net money flowing out of the markets, then they fall. All this is self-evident. In fact, saying that there is money flowing into the markets so they are rising is almost a tautology. It's just the same thing said in two different ways.

As practical investors, it is more important to know, if possible, why there's money flowing into the markets, what kind of stocks is it coming into, what is the future perspective of those whose money is coming in, is it just momentum or do they see opportunities, are they likely to be right and so on and so forth. How much of the money has any conviction and how much of it is just a bandwagon effect? The devil (or rather, the profits and losses) are in the details.

Nowadays, with the equity markets moving up strongly, we have had a lot of speculation as to why this is happening. Surely, even though the immediate impact of the Chinese virus has been less sharp than once feared, the story is not over yet. World over, businesses and individuals are reeling from the impact and scale of the eventual damage and so the strength of the stock market is a little incongruous.

The result of all these incongruities is that there is now way too much speculation about why markets are going up so relentlessly. A large proportion of investors are deeply worried about this apparently irrational rise and the obvious culprit is liquidity. Central banks in the western countries now have only one trick left, which is to pour in more and more money into the economies. All things said they can't be blamed for it under the circumstances but the scale is quite crazy.

According to data on the US Federal Reserve's website, something like 40 per cent of all dollars that exist today were created since March 1, 2020. This number is going up every day and you can check the latest at https://bit.ly/printdollars. That's a lot of money that just has to go somewhere.

As a counterpoint, it's easy to come across opinions in the media and from analysts that liquidity alone cannot drive up the markets for a long time. The canonical example is that of the Bank of Japan, which has been trying this trick for decades now but to little lasting effect. There are other examples as well if anyone is looking for instances of liquidity not being able to sustain the equity markets.

Now you'll agree that you and I do not have a huge interest in academic and theoretical arguments about liquidity and central-bank strategies and whatnot. We are practical investors and we are here to make money from the markets. From that standpoint, this liquidity debate is useless.

The growth of the markets is like the growth of a plant. You need the soil, but the soil alone will not do the job. The soil, the seed, the weather, the fertiliser, the water - it's all needed. Those who are arguing whether liquidity alone can do this are just engaging in pointless debate. The liquidity is the fertiliser, it can cause some rapid growth but for the plant to take hold and become a tree, everything else has to be right.

So, what are we to do? Our job is not to bother about all this. Some of these plants will die out when the fertiliser runs out and others will take root and become big trees and bear fruit. At Value Research, we are here to identify those trees and share that knowledge with you.