Does QE Drive the Stock Market?

Did Bizarro Superman ever make an appearance in Australia? You might know him as the ‘Champion of the Legion of Doom!’ He was the occasional star of the US animated TV show Super Friends. And regular foe of Superman. There’s a reason we ask, so bear with us.

Bizarro Superman came to life when a duplicator ray hit Superman. Yet the resulting being was the exact opposite of everything Superman stands for. He lived on Bizarro World, which was a cube rather than a round globe. On his planet it was a crime to do anything good. He even flew backwards!

We’re in a financial Bizarro World today. Just take a look at the US… On the surface, the world’s largest economy is showing surprisingly strong job growth and corporate earnings. It looks like America’s over-indebted government might finally be able to start trimming some of its excessive spending and reining in its runaway debt. Which in turn means the Federal Reserve can stop providing artificial support. That should be a boon for the markets, right?

Apparently not. Welcome to Bizarro World.

Bloomberg reports that taper fears are back and weighing on the stock market. Some investors are shorting the market in anticipation that the Fed’s quantitative easing (QE) gravy train may be nearing the end of the tracks. It’s just like in the lead up to September, when tapering was all over the headlines too.

The result of the uncertainty is that markets are still around their highs, but with a reluctance to push higher. Overnight, the DOW and the S&P 500 dropped a smidge. Gold is trading especially low at US$1265.

All this supposedly on the mere hint that a taper may be coming along sometime in March 2014. Not an end to the Fed’s bond buying, mind you. Just a reduction from today’s $85 billion per month down to $70 billion, or whatever figure they pull out of thin air.

We can only imagine the investor panic that will ensue if the US economy continues to pick up speed. What if the Fed actually ended its bond purchases? We might all have to stop flying backwards.

Then again, what if QE is a bubble?

No, not causing a bubble, but a bubble in and of itself. What if it has absolutely no effect on…anything?

‘That’s ridiculous! Haven’t you seen the stock market going up with the money supply?’ you ask incredulously. After all, you read about it in Markets and Money.

Here’s the corresponding chart to that argument, not that it’s relevant to the point we’ll make below. As you can see, when the Federal Reserve’s balance sheet expands (QE) the stock market rises. Since 2008, a pause in QE led to falling stocks. And so the Fed embarked on QE Infinity at a pace of $85 billion a month. Stocks have soared ever since.

click to enlarge

But these sorts of charts can be very misleading. Over the past few weeks, Dr John Hussman has been on a warpath in his weekly newsletters on this topic. We’ll quote from some of them below.

Let’s start with his conclusion: QE isn’t even a real drug. It’s a placebo that’s working  to goose the stock market right now. But placebos don’t fix problems. They don’t even have a real effect. They might make you think you’re healthy for a while. But the underlying disease continues on. And even the symptoms aren’t actually numbed.

The problem and risk of a placebo solution is that the psychological effect can disappear darn fast. If you figure out you’re only taking placebo pills, the belief that they work disappears too. Then things can turn very nasty very quickly.

So what evidence is there that QE is just psychological trickery? Well, first of all, the evidence touted that QE and the stock market are related is pretty slim:

Though one can show a very high correlation between the level of the monetary base and the level of the S&P 500 since 2008, the fact is that two reasonably diagonal lines will almost always be correlated more than 90%… If you have a four-year old child, I can nearly guarantee that over the past four years, the correlation between the level of the S&P 500 and the height of your child has been over 90%. Heck, since the end of 2008, the correlation between the S&P 500 and a diagonal line has been 95%.

This is the old ‘correlation is not causation’ story. But when it comes to money and the stock market, the idea that money printing makes stocks to go up does make intuitive sense. More money has to flow somewhere, after all.

The thing is, when central banks create new money, they inject it into the economy by buying something. Whatever it is they are buying disappears from the economy and money appears in its place. Usually, all this lowers the interest rate — a measurable change and one that affects the economy directly by changing the amount people pay on their mortgages and other debts.

But when interest rates are zero, or near zero, then fiddling with the money supply by swapping cash for other assets might not really do much. Especially considering the assets the central banks are buying. And who from.

Most of the purchases are of government bonds. Swapping cash for government bonds on the balance sheet of banks, where the Fed buys them from, is like swapping butter with margarine in your fridge. Government bonds are just promises to pay cash, after all. And at 0% yields, there really isn’t much difference between the cash and bonds. Especially as banks can use Treasuries as collateral in the sort of gambling transactions they prefer over actually lending people money.

So perhaps all this QEing around is just shuffling deckchairs on the Titanic. It has no real effect.

If you’re dazed and confused by this idea, the little tidbit you might be missing is this: If the government runs big deficits while the central bank buys up bonds at the same time, this can create the kind of liquidity which causes inflation. That’s because the spending the central bank is financing, directly or indirectly, is then very real. And it reaches the real economy.

But that kind of ‘real economy’ liquidity doesn’t turn up in the stock market as directly because governments don’t buy stocks. Except during crises when bailouts are ‘required’.

The US government’s deficit has actually been shrinking fast lately. From an absurd height of course. But shrinking nonetheless.

Our tentative hypothesis is that the implicit government bailout which stands behind banks and large corporations is de-risking the stock market. That’s why it’s going up. The government will save the day if anything goes wrong. Central banks can keep the financial system liquid, not goose the stock market.

Instead of watching QE, it’s fiscal balances that you need to be aware of. And Europe and Japan are the wildcards on that measure.


Nick Hubble+
for Markets and Money

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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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