How to invest: Investors cautiously returning to stock market

FOLLOW THE MONEY.

If recent reports are correct, that shouldn’t be too hard because there’s plenty of spare money around looking for a place to invest.

Canadians and Americans, it seems, have salted away billions of dollars during the economic recession and are starting to put it back into the market.

A CIBC World Markets report has found that Canadians have $45 billion in surplus cash that they normally would have invested in the stock market, about 10 per cent of the total personal liquid assets in Canada.

Another report by the Investment Funds Institute of Canada found that Canadians had $73 billion in short-term money market funds last May, an increase of 6.4 per cent over the same month in 2008. That amount represents about eight per cent of the value of the S&P/TSX 60 index.

South of the border, nearly half the value of the U.S. stock market is parked on the sidelines in short-term investments.

"The money is coming back but slowly, because it is so difficult to time this market (to buy at a low and sell at a high)," says Patricia Lovett-Reid, senior vice-president at TD Waterhouse.

Liquidity, or the amount of money flowing through all parts of the financial system, is a vital component of financial markets and economies, and an important tool that investors can use to make investment decisions.

"Keeping an eye on liquidity can help distinguish between market slumps that are really buying opportunities and signs of serious economic problems," Jack Ablin, chief financial officer of Harris Private Bank, says in his book, Reading Minds and Markets.

"The first question to ask is whether lenders throughout the financial system are making it easy or difficult to borrow," Ablin says. "The easier it is to obtain money, the greater the liquidity and the greater the potential for some of that capital to flow into the stock market."

The primary measure of liquidity is M2, a broad measure of money supply growth that tracks how much cash-like assets Canadians and Americans own.

"When M2 surges, that’s good news for stock market returns," Ablin says. "If money supply grows faster than inflation, that’s bullish for stocks because money is becoming more abundant."

Another good measure of liquidity is mutual fund flows.

This information is reported monthly by the IFIC and shows how much investors are allocating to certain kind of mutual funds, how much is being withdrawn and the net impact, whether positive or negative.

"It is showing that liquidity is returning, but there is still a fair amount of money to come back into the market," says Lovett-Reid.

"The theory is that, over time, tracking flows will give you a broad picture of liquidity in the shape of the number of dollars flowing into or out of mutual fund coffers," Ablin says. "You can also drill down and see what is happening within key sectors."

Another way investors can detect liquidity problems is by monitoring credit spreads, the difference between Treasury and non-Treasury securities that are identical in all respects except for quality rating. The greater the amount of liquidity, the narrower is the spread, and vice versa. Narrow credit spreads are consistent with easy money — another name for strong liquidity.

The results of a Harris Private Bank study have showed "a strong metrics-based argument for staying invested in stocks when credit is easy and liquidity abundant, and for becoming cautious only when lenders begin to restrict credit. On the flip side, tighter credit conditions suggest investors (become) risk averse and that making money in the stock market could be difficult."