Many people believe earnings and valuations move the market. They matter, but when you look at the market as a whole, another force often matters more: liquidity.
Supply and demand is the mechanism
Every price is set by buyers and sellers. When more people want to buy than sell, the price rises. When more want to sell, it falls. That is the underlying mechanism, and it never changes.
The harder question is what makes buyers outnumber sellers across the whole market, for months or years at a time. In many of those periods, the answer is the amount of money available to buy.
What liquidity means
Liquidity is the supply of money moving through the financial system, and how cheaply it can be borrowed. Central banks influence it through interest rates and through the assets they buy. When money is plentiful and cheap, more of it looks for a home in shares, bonds and property, and prices tend to be supported. When money tightens, the reverse can happen.
Investors who trade the macro picture, such as Stanley Druckenmiller, have long argued that central banks and the flow of liquidity matter more to the overall market than company earnings.
This is the thinking behind an old market saying, “Don’t fight the Fed”. It reminds you that going against the direction of central-bank policy has often been costly.
From central banks to prices
- Link 01Policy sets the toneInterest rates and asset purchases shape how cheap money is.
- Link 02Money in the systemWhen money is plentiful, more of it looks for a home.
- Link 03More buyersShares, bonds and property attract that money.
- Link 04Prices supportedOften, but not always. Earnings still matter.
A simplified picture. Many forces act on prices at once, and none of them is a certainty.
A look at 2009 to 2020
The decade after 2008 makes the point. Growth was modest for much of it. Inflation stayed low. Confidence in where the economy was heading was often shaky. Yet the S&P 500 climbed through one of the longest bull markets on record.
The S&P 500 at each year end, 2008 to 2019
Closing level on 31 December each year, plus the March 2009 low. Axis labels mark the start of each year. Rounded. A single chart cannot prove a cause, and past moves do not predict future ones.
Over the same years, the US central bank’s balance sheet grew from under $1 trillion to several trillion dollars, and interest rates stayed near zero for long periods. Liquidity is widely cited as one reason prices kept rising. It was not the only one, and nobody can prove a single cause.
Earnings still matter
None of this means earnings are unimportant. Over time, earnings and valuations help explain which companies do better than others. A useful way to think about it: liquidity often shapes the broad direction of the tide, while earnings help explain how individual boats sit in the water.
The same logic applies in India, where the Reserve Bank’s policy and global money flows also shape the broad mood of the market.
What a chart reader takes from this
Forecasting liquidity is hard, even for experts. Price, on the other hand, is already there on the chart. It carries the net result of every force at work: liquidity, earnings, policy, fear and hope. That is why we read price first.
It also explains why risk limits matter. When the tide turns, markets can reverse quickly, and a plan that defines the exit beforehand is easier to follow than one made in the middle of a fall.
Keep learning.
MadhusudhanFounder and Mentor, Mars Equity
This article is for education. It is not investment, financial or personal advice, a recommendation or an offer to buy or sell any security. Markets carry risk, including loss of capital. Index and balance-sheet figures are approximate, historical and illustrative, and views quoted are those of the people named.