WIth all of the hoopla about economic recovery still filling the airwaves, it is curious indeed why the market is losing ground this earnings season when earnings are coming in better than expected across the board.  The explanation is very simple.  This rally since last March has been about the banks having access to free money and funneling it into the market through their trading desks.  Earnings, GDP, etc. have nothing to do with it. 

World governments have been trying to spend their way to prosperity, but of course that never works.  The thinking was to keep things going until the world economy rebounded, but just one look at the U.S. unemployment rate shows that things are, in fact, not getting better. 

China has been the leader in this recovery attempt due to their loose monetary policy and their propensity to stockpile raw materials.  Two announcements in January, however, show that China is now beginning to tighten their monetary policy for fears of stoking widespread inflation.   The draining of the liquidity pool is beginning to show up in the shares of the Shanghai Composite.  In the chart below, I have plotted the Shanghai Composite (black line) along with the S&P 500 (red line).

Notice how the Shanghai Composite actually bottomed in October 2008, a full five months before the S&P 500.  After testing the low in December 2008, the Chinese market began making a succession of higher highs and higher lows.  Speculation ran rampant as liquidity flooded the marketplace.  In August, the Shanghai made its final high.  After a sharp sell off, the rally resumed, but the August highs were never eclipsed.  That was telling is that something was on the way, namely tighter monetary policy.  Notice how the S&P pushed out to new highs last month while the SHanghai was breaking down, making a succession of lower highs, forming a triangular consolidation pattern.  Just this week the Shanghai broke down out of that pattern signaling trouble ahead.  This is an important leading indicator for our market as the S&P 500 has been responding merely to excess liquidity, not market fundamentals.  With India now saying that they are undertaking steps to drain liquidity, it is just a matter of time before other nations begin to tighten and this party is declared over.