The Impact of Declining US Market Liquidity on the S&P 500

 

The Impact of Declining US Market Liquidity on the S&P 500

Liquidity is one of the key factors influencing stock price movements in the US market. Recently, a notable change in the relationship between the Federal Reserve's Liquidity Index and the S&P 500 index has been drawing significant attention from investors.

Historical Relationship Between Liquidity Index and S&P 500



The graph above compares the Fed Liquidity Index (red line) with the S&P 500 Composite Price Index (black line) from 2009 to January 2025. Several important patterns can be identified in this chart:

  1. Long-term Correlation: Historically, increases in aggregate US liquidity have had a positive impact on the stock market. When liquidity increases, stock prices generally tend to rise.

  2. 2009-2013 Period: Following the financial crisis, the S&P 500 showed steady growth alongside the Fed's expanded liquidity supply.

  3. 2013-2017 Period: While the liquidity index maintained relatively stable levels, the S&P 500 demonstrated moderate upward momentum.

  4. 2019-2021 Period: The liquidity index rose sharply in response to massive liquidity injections during the COVID-19 pandemic, followed by significant increases in the S&P 500.

  5. Recent Trends (2023-2025): The most notable aspect of the graph is the recent trend. We can observe a "decoupling" phenomenon where the liquidity index (red) is declining while the S&P 500 (black) continues to rise.

Implications of Recent Liquidity Reduction and Market Impact

Currently, the Fed Liquidity Index shows a downward trend, which can be attributed to the Federal Reserve's interest rate hikes and quantitative tightening policies. Meanwhile, the S&P 500 still maintains high levels, creating an unusual situation where stock prices remain elevated despite diminishing liquidity.

This divergence may suggest the following market conditions:

  1. Increased Market Vulnerability: Since liquidity reduction generally has a negative impact on asset prices, the current high stock price levels may potentially be vulnerable.

  2. Potential for Correction: Historically, such divergences often eventually lead to corrections. If liquidity continues to decrease, the S&P 500 may face downward pressure accordingly.

  3. Influence of Other Factors: Other factors such as corporate earnings, technological innovations like artificial intelligence, or investor sentiment may be offsetting the effects of reduced liquidity.

Connection to Recent Market Conditions

This analysis is particularly significant as it was released following the global stock market decline that began on April 2, 2025. The market downturn was triggered by the announcement of US tariff policies under President Trump's administration, which significantly increased market volatility.

In fact, the VIX, known as the fear index, rose to 45.31, its highest level since 2020. This indicates how unstable the market currently is.

The Relationship Between Liquidity and Asset Prices

The relationship between liquidity and asset prices, frequently mentioned by Lance Roberts, has been confirmed in various studies. According to a 2021 ISS Governance study, differences in liquidity among S&P 500 stocks affect trading strategies and price stability.

Liquidity is an indicator of how smoothly funds flow in the market. When liquidity is abundant, asset prices generally rise and trading is active. Conversely, when liquidity decreases, asset prices may face downward pressure.

Implications for Investors

In the current situation, investors might consider the following points:

  1. Review Defensive Positions: If the liquidity reduction trend continues, it may be necessary to review the proportion of defensive assets in portfolios.

  2. Importance of Sector Selection: Sectors that are relatively resilient in reduced liquidity environments (such as consumer s

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