It was in the 1960s when Liza Minnelli and Joel Gray sang ‘Money makes the world go around,’ and it was as true back then as it is today. The more money, the faster the financial world spins and vice versa.

Money/liquidity is as important for the stock market as gasoline is for a car. Since the Fed’s QE2 inflated a liquidity-based bubble, the key question was where the money will come from once QE2 ends.

As long as there is no QE3, the issue of money flow is one of the keys to deciphering the future for stocks (NYSEArca: VTI). Published below is a revealing piece of cash flow analysis featured in the June 2011 issue of the ETF Profit Strategy Newsletter (released on May 20):

Don’t Fight the Money Trail

‘QE2 – one of the sources that has been copiously showering Wall Street – is about to come to an end. Will there be enough new cash on the sidelines to continue driving up stock prices?

The chart below says a thing or two about investable cash and how much is left. At the top we see the S&P and the giant M-pattern discussed previously. Illustrated below is a measure of investable cash.

Using NYSE figures (latest available as of March), I’ve deducted free credits (available cash) from debit balances (margin debt) to come up with investable cash. Shown at the bottom of the chart are mutual fund cash levels.

Investable cash in March was almost as low as in June 2007. There are two variables that might be affecting investable cash:

1) Interest rates are lower today than at the previous investable cash lows in 2007 and 2000. This means margin accounts could expand further.

2) The number of creditworthy borrowers and lending activity has gone down, which may keep a lid on investable cash expansion.

Mutual fund cash levels are easier to interpret. They are at 3.4%, an all-time low.
The numbers allow for only one logical conclusion. Without the generous monetary policy (QE2 is slated to end June 30) there is very little new cash left to drive stock prices higher. Without that cash fix the market will crash like an addict forced to go cold turkey.’

Bad Timing

The Fed’s withdrawal from the stock market came at the worst of times because:

1) The S&P was forming the giant bearish M-pattern shown above
2) Seasonality turns bearish from June – October
3) Europe had been playing Whac-A-Mole with its debt problems
4) The Fed’s QE2 failed to lift the economy and investors became suspicious
5) The financial (NYSEArca: XLF) and banking sector (NYSEArca: KBE) was weak

The bearish M-pattern wasn’t on anyone’s radar, that’s what makes it so powerful. As per the ETF Profit Strategy Newsletter’s interpretation, a move above 1,369 would render the pattern complete. The April 3 ETF Profit Strategy update stated:

‘There is strong Fibonacci projection resistance at 1,369. In terms of resistance levels, the 1,369 – 1,382 range is a strong candidate for a reversal of potentially historic proportions.’

How Much Worse Can it Get?

The S&P (SNP: ^GSPC) has lost over 10% in 10 days. The Russell 2000 (Chicago Options: ^RUT) lost 15% in 10 days, the Dow Jones (DJI: ^DJI) 10% and the Nasdaq (Nasdaq: ^IXIC) 9%. The VIX (Chicago Options: ^VIX) recorded its biggest gain since last year’s ‘Flash Crash.’ How much worse can it get?

The answer is probably two-fold:

1) Stocks will only fall so long before they bounce. After such a sizeable drop there will be some kind of a bounce, probably even a powerful relief rally.

2) Stocks dropped below two multi-year trend lines. Technical analysis 101 suggests a change of trend from up to down has occurred.

From a trading point of view the current constellation is tricky. The market is oversold, but some of the biggest declines occur in an oversold condition (this is the reverse scenario of the late 2010/early 2010 bull run).

Thanks to a contribution by an astute subscriber, the August 2 ETF Profit Strategy update noted the following about the VIX: ‘The VIX is currently climbing the upper Bollinger Band.  This is a pattern we’ve seen in April 2010 and September 2008. Yesterday as in 2008 and 2010, a buy signal was triggered; nevertheless the VIX kept climbing the Bollinger Band until the eventual crescendo was reached. In October 2008 the VIX topped at 96.4, in May 2010 at 48.2. Currently the VIX is below 25.’ After Thursday’s collapse the VIX is at 31.85.

How to Proceed

The ETF Profit Strategy Newsletter did capture much but not all the gains to be had on the short side. More importantly it told conservative subscribers to get out of stocks at S&P 1,340 and simply wait in cash.

One subscriber sent us a thank you e-mail after yesterday’s close and summed up his experience like this: ‘Thanks! Your August newsletter plus some common sense just saved my entire portfolio today!! No losses suffered, no looking for gains.’

Rather than making big bold long-term predictions right now (many of you are probably familiar with my bearish long-term outlook anyway), I will continue to follow the market’s lead.

The S&P hasn’t quite reached the lower target (support) for this decline yet, so it is prudent to wait and see if it gets there. If it does, it may set up a short-term buying opportunity. If it doesn’t, I’ll wait to see how the S&P performs at the next resistance level.

The ETF Profit Strategy Newsletter provides a common sense, low risk- high reward approach to investing. Yesterday’s special update includes the support levels likely to halt the free fall and elicit a tradeable bounce along with a target level for the ultimate market bottom.