For the last four years the Federal Reserve has been actively engaged in supporting the stock market by suppressing interest rates to historically low levels, and injecting liquidity into the financial system, through a variety of different programs. The most notable, and widely discussed, of these programs has been the Large Scale Asset Purchase programs (see here and here) which have become known as Quantitative Easing or Q.E.
There are two important considerations revolving around Q.E. programs. First, the Fed is currently simultaneously involved in two Q.E. programs totaling $85 billion a month. Considering that we are more than 4 years into an “economic recovery” the need for such liquidity injections is very telling about the real strength of the economy. Secondly, each program has had a diminishing rate of return as shown in the combined chart below.
What the chart shows is the history of each program from its inception post decline to May 31st of the following year. The first QE program followed the 48% decline in the S&P 500 due to the financial crisis. From that low point the markets rallied 34% to the end of the program 2010.
Following the expiration of QE 1 the market declined by 14% which pushed the Fed to enact QE 2 in order to “stimulate consumer confidence and boost asset prices.” QE 2 worked as planned and boosted the market by 28% until its conclusion in the early summer of 2011.
As witnessed previously, as the effects of the Fed’s liquidity was extracted from the system, the market deteriorated and fell 19% as the economy slowed and the first debt ceiling debate ensued. Worried that the economy may well slip into recession the Fed acted to once again support the financial markets, and the economy, by utilising a different approach and implementing a bond reinvestment program which became known as “Operation Twist.” From the lows of the market in the summer of 2011 the market was only able to muster a 19% increase before stalling and declining once again by 10%.
The story line changed somewhat in 2012. As the market declined in the early summer of 2012, with the Eurocrisis once again rearing its head, the markets, now very accustomed to the Fed intervening and providing support, began to advance in anticipation that Bernanke’s “printing press” would once again be unleashed. Like the sound of the bell to Pavlov’s dogs, the market rallied strongly during the summer months reaching its peak as the announcement of QE 3 was made in September. QE 4 was announced shortly thereafter to replace the expiration of the “Operation Twist.”
The recent rally has attracted much attention as the markets flirt with their highest closing levels since the 2008 stock market crash. For many individual investors they are now back to where they were five years ago. I need not remind you that getting back to even is not an investment strategy. The question, however, is how much further the advance can go? (Note: For clarity purposes I have intentionally left out Operation Twist since that program did not expand the Fed’s balance sheet.)
In hindsight it is easy to see that there was a direct impact from the Fed’s operations on asset prices. However, in real time it is a bit more difficult. The recent year end surge has sent the media scrambling for to assign reasons for the rally. Is it improving earnings? A better economic outlook? The reasons have been plenty from the steady steam of analysts and managers on television. However, with earnings currently showing little sign of improvement, and the economy likely to slow down sharply from the 3rd quarter of 2012, the answer is likely more simplistic and can be quantified to $85 billion a month.
What we are witnessing is the impact of the Fed’s liquidity operations once again pushing money out of safe haven investments, namely the U.S. dollar and Treasury bonds, and into risk assets. The current push higher pulled investors off the sidelines and into the market as witnessed by overly bullish sentiment and extreme complacency as measured by market volatility.
The chart below shows the effect of QE programs on interest rates. QE programs push investors out of the safety of Treasury bonds and into equities which leads to an increase in interest rates. As you can see each previous program has led to a fairly sharp rise in rates and we are now beginning to see that rotation once again in recent weeks. (Side note: This is potentially a problem for the housing market recovery thesis)
The U.S. dollar is likewise affected by the push into risk assets. As shown in the next chart the dollar has been a store of value during times of market crisis or economic concerns. However, during QE programs the dollar has declined as money is rotated out the U.S. dollar and invested into risky assets.
What is clear is that the recent market rally is once again being driven by the Federal Reserve’s QE programs. Money is flowing out of bonds, and the dollar, and into equities. The weekly chart below shows the decline in the market this past September and October as excess reserve balances with the Fed were drawn down. The subsequent rally has been fuelled by the Fed as it has pumped reserve balances sharply higher.
The question of how far the rally will likely go is shear speculation. Using past history as a guide I currently think that the market could reach our intra-year target of 1560 as shown in the first chart above within the next three to four months. After that, however, I suspect that a resurgence of economic weakness caused by increased taxes, potential spending cuts and a continued drag from emerging markets and the Eurozone will begin to negatively impact the markets. The chart below shows the likely trajectory in the months ahead.
However, as with all forecasts and projections, it is simply my best guess based on my assumptions about the future. What is clear is that the markets are once again very overbought and while the market could very well rally further from here – it has not been a wise bet to assume that the advance will continue indefinitely. The reality is that we are very long in the tooth in this current rally and we are now seeing a multiple expansion based on rising prices and deteriorating earnings. Such an event has never ended well – although it can last far longer than is generally imagined.
Ben Bernanke’s fingerprint is clearly present in the current rally. The trend is currently positive and internal dynamics are relatively stable as money rotates from safety into risk. However, as stated above, the markets are overbought, overly bullish in terms of sentiment and complacency, and fundamentals are showing signs of weakness. While 2012 made a very strong advance in the face of rather substantial headwinds it is unlikely that 2013 will repeat such a showing.
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