How The Supply of Liquidity Affects the Black Publicly Traded Firms

We have recently been making the argument, with increasing force, that Alan Greenspan and the Federal Reserve are not supplying enough liquidity to satisfy the demand for it in the marketplace. And we have made a connection between this lack of liquidity and the economic fortunes of the Black publicly traded firms in particular and the Black electorate in general. Today we would like to explain how this process works, for the Black-owned firms.

First, we equate liquidity with the monetary base, which is usually defined as bills and coins in circulation plus banks' cash on hand and their reserve balances at the Federal Reserve banks. The Federal Reserve, having a monopoly on the issuance of currency and on monetary policy is the dominant force in determining the amount of liquidity available in the marketplace.

As we have previously indicated, the price of gold is the best signal of whether or not sufficient liquidity is being supplied to the marketplace. This is due to the fact that gold is the most monetary of all commodities - the most sensitive to the supply of liquidity.

Once an equilibrium price of gold has been established, one can easily tell if adequate liquidity is being supplied by watching the movements in the price of gold in the financial marketplace. For example, if a gold price of $275 per ounce is established as equilibrium then if the price rises to $280 that is an indication that the Federal Reserve has supplied too much liquidity. And conversely, if the price of gold falls to $270 per ounce, it is a signal that too little liquidity has been supplied.

In order to bring the gold price back to equilibrium, in the first case, the Federal Reserve would conduct open market transactions through one of its 30 primary dealers and sell Treasury bonds into the marketplace to mop up excess liquidity until the price of gold reached $275 and in the latter case the Fed would purchase Treasury bonds and inject liquidity until the price of gold reached $275.

Currently, we argue that the price of gold which yesterday closed at $266 per ounce is deflationary and evidence that not enough liquidity has been injected into the system. Thus, we advocate that the Federal Reserve purchase Treasury bonds from banks and inject liquidity into the system.

We accept 1999 Nobel Prize Economist Robert Mundell's recommendation that the Fed purchase bonds until the price of gold reaches $310 per ounce.

How would all of this affect the Black publicly traded firms?

In at least one of three ways.

First, the injection of liquidity means that banks are flush with new cash with which to make new loans. As an example say an extra $10,000 is on the books of one of the most marginal of banks. This bank now can make a loan or extend credit to one of its customers. It subsequently makes a loan for $10,000 to a customer who opens a hardware store in Southeast Washington D.C. This storeowner in turn takes $1,000 of that $10,000 and buys advertisement time and commercials from a radio station in Washington D.C. owned by Radio One (ROIA) - one of our Black-owned stocks. Out of that $1,000, Radio One can expect 25% of that to reflect a profit. This may translate into one cent more in earnings for the entire company and now, in the eyes of analysts, Radio One is worth one penny more and should be valued at a higher stock price.

This one-cent increase in the estimated value of ROIA indicates that the company is stronger than it was before and enables the company to attract more investment from investors who are considering "risky" investments.

In this first example it can be said that liquidity drives profits which drive stock prices.

Second, the injection of liquidity from the Fed could mean that a $10,000 loan finds its way right into the stock market when an investor borrows the full amount and pours all or some of it into ROIA stock.

Third, a marginal investor who is aware of the gold price signal sees that the price of gold has risen significantly as a result of the Fed's injection of liquidity. That investor, knowing that for a brief period of time, ROIA's stock price may now reflect a now bygone era of a deflationary monetary policy from the Fed, quickly jumps on the opportunity to invest in liquidity-starved stocks like ROIA. This investor then takes cash out of his or her portfolio and invests it in ROIA, with the expectation that demand for the company's stock will increase as more and more liquidity finds its way to the company - in the form of direct investment or profits.

The most important principle to understand in all of this is the fact that optimum liquidity allows the flow of funds to go to the most risky enterprises. When the Fed is supplying the optimal amount of liquidity, the marginal investor is more willing to take a risk and pour money into these firms.

And because the Black-owned stocks are some of the most "risky" by nature of their small size and relatively few years of existence, they stand to benefit the most, proportionately, when new liquidity enters the marketplace.

Investors assess risk and the investor that invests on the margin, who is the most sensitive to market changes and dynamics, is watching to see how the Fed manages liquidity.

Currently, with a gold price of $266 per ounce and an inverted yield curve where short-term interest rates are higher than long-term rates, many investors believe that the Fed has made a monetary policy error and has squeezed liquidity out of the marketplace.

In the current deflationary environment, these investors consciously avoid risky investments like the Black-owned stocks.

On January 3, many investors believed that Alan Greenspan's decision to lower the Federal Funds rate would be an adequate response to reverse the Fed's monetary policy error, but it was not. When the Federal Reserve lowered interest rates on that day the markets shot up in anticipation of increased liquidity hitting the marketplace.

But soon the markets receded as it became apparent that lowering the Federal Funds Rate was doing nothing to end the drought. By January 8, the market was almost down to the lows it had reached before the decision to lower the federal funds rate was announced.

Many analysts recognized right away that lowering the fed funds rate would not result in a sufficient increase in liquidity, as the price of gold did not move upward immediately after the rate cut was announced. The inertia in the price of gold during this time period and to the present is the true signal that sufficient liquidity has not been added to the marketplace.

We estimate that it will not be until the price of gold rises above $275 per ounce and is sustained, that micro-cap stocks will begin to break out of their current trading ranges.

If the Federal Reserve would announce that it is targeting a gold price of $310 per ounce, we believe that it would result in enough liquidity in the marketplace that not only would the Black-owned stocks rise in value but if the proper fiscal policies were enacted and implemented by Congress and President Bush, it could result in several revenue-generating and profitable private Black-owned enterprises going public through initial public offerings (IPOs) - creating a boom that spreads throughout the Black economy.

Cedric Muhammad

Tuesday, January 23, 2001

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