Some experts believe that the tight correlation between stock prices and the
Federal Reserve’s growing balance sheetproves that the stock market is effectively being driven up by the Fed.
In other words, they believe this correlation looks more like causation.
But Bank of America Merrill Lynch’s Ethan Harris thinks that’s ridiculous. From his recent note:
We believe this chart is an example of “spurious correlation” — a high correlation between two series that is coincidental rather than causal. One of the big no-no’s in statistics is to correlate two trending variables, because the correlation will tend to capture the separate time trends in each variable rather than the interaction between the two variables. This is a very common problem for macroeconomic data and asset prices because the business cycle triggers long co-movements among many variables. To put the correlation in perspective, over the last 5 years the Fed balance sheet has a correlation of 0.92 with the CPI, and a huge 0.97 correlation with new truck prices. Both the population and the price of alcohol have a 0.91 correlation with the Fed’s balance sheet: taken literally the Fed is pushing people to drink, drive and have children.
The fear by many is that the tapering and eventual end of QE means the end of the stock market.
Then again, others argue that the end of QE would only happen when the economy is back on track, which could bolster the market.