The Stock Market, Leading Indicators, QE & the Bernanke Put

We’ve covered QE quite a bit over the years.  I’ve repeatedly referred to it as the most over-hyped policy, perhaps ever.  After all, it’s just an asset swap of reserves for bonds that doesn’t change the private sector’s net financial assets, perhaps changes interest rates marginally and primarily works via the questionable “wealth effect” it has by getting high frequency traders all excited.

So it was interesting in recent months after QE3 was initiated when some economists started cheering the positive impacts the Fed was having on the economy because the stock market started to rally.  The problem is, the stock market is not really a leading indicator of anything.  The stock market is the summation of the guesses from a bunch of highly irrational participants using highly inadequate information to place these guesses.  Further, the entire premise of a “wealth effect” from the stock market is flawed because the stock market is actually nominal wealth.   To make your spending decisions on the current values of the price of Apple or the S&P 500 is a highly unreliable way to earn an income (not that some people don’t do it, but most people don’t).  If the policy in QE doesn’t actually translate in a real change to the underlying assets the S&P 500 represents then any nominal wealth changes (as a result of inefficient guesses) will not likely last (thereby creating only a temporary wealth effect)  So the impact of this “wealth effect” is highly questionable to begin with.  It has a certain ponzi aspect to it similar to a company that just buys back shares perpetually without ever actually investing anything in its underlying operations.  That might boost EPS for a while, but eventually the growth of profits needs to be established by more than just fewer shares outstanding.

Anyhow, I rambled on quite a bit there.  But as the market tumble a bit here I have to keep asking this question that I’ve been asking since QE3 was initiated.  Did the Fed just buy high only to sell lower?  QE1 & QE2 were established when the market was cratering.  So the market’s response afterwards gave the appearance that the Fed’s policies were highly effective.  But QE3 was established after a huge rally in the stock market.  Does that mean we will finally be able to put the nail in the QE coffin if the market doesn’t respond as it did following QE1 and QE2?  Probably not.  Faith in monetary policy is something that will never die.   That faith might not be misplaced outside of a balance sheet recession, but in the current environment we’re still betting on a naked emperor….


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. “QE1 & QE2 were established when the market was cratering.”

    Whenever 5 year forward 5 year inflation break even cratered to the 2% level the Fed triggered QE1 and QE2.

    The recent break even level did not justify QE3 and the current level certainly doesn’t justify additional QE (current read 2.98). The highest level reached was 3.19 on the 25th of April 2011 in the last 5 years with the lowest point reached on the 31st of December 2008 at 0.41.



  2. I don’t blame Bernanke for trying voodoonomics via QE3. I think he knows that confidence plays a role in the direction that an economy will take. And he knows that congress has been a huge roadblock the past 2 years.

    July 2010: Bernanke asking for fiscal stimulus.

    Ask yourself – are you feeling more or less positive about the economy now compared to a year ago? Does it have anything to do with the stock markets shooting up?

  3. QEnfinity a failure? never! it was just not big enough. time to restart the late day rumor mill, how that fed will increase/extend asset purchases. ;)

  4. I don’t think the QE programs were designed to pump start either the stock market or the economy. QE is all about buying distressed assets so that banks and financial institutions don’t fail or become zombies.

  5. QE was – IMO – meant to prop up markets. The US has a Current Account Deficit and is therefore at the mercy of foreigners to recycle those USD back into the US. But it requires higher asset prices to lure those investors to buy US securities. That’s why Benny Bernanke did all those QEs.

    But all around the world earnings are going down. Including in the US.

  6. QE is NOT about buying distressed assets. If you want, you can argue that TARP/Maiden Lane/TALF (to name a few) were about distressed assets to some extent, and even then, the impetus was to sequester non-performing/illiquid assets to unfreeze credit markets. While you could argue that some agency MBS & ABS were garbage credits (and I would), the government’s implicit thesis was that these assets were merely suffering from illiquidity.

    In the example of TALF (specifically PPIP), collateral quality standards were “slightly” compromised–but that depends on the efficacy of ratings agencies. Maiden Lanes were toxic heaps, yes.

    Traditional QE (QE2 & QE3) is not about buying distressed assets though… just to be clear.

  7. Color my cynical. As Cullen suggests, the policy doesn’t do what the Fed says it will do — and surely the Fed knows this. So either the Fed is being deceptive or incompetent.
    If we’ve got financial houses giving up securities that presumably have value and are paying interest, you have to wonder if those investmens are so valuable, why don’t they sell them on the open market? Why do they want to get rid of them for low-interest cash?
    Or if the Fed wants to release reserves into the system, why doesn’t it just lower the reserve requirement.
    The Fed doesn’t have to answer questions about what it’s doing; or, it gives deceiving or misleading answers. So why trust what they’re doing?

  8. “Faith in monetary policy is something that will never die”

    The Fed’s always reacts, not acts (it’s always late).

  9. I noticed the same issue as far as when QE3 was launched in reference to market cap. I think that some of that had to do with markets expecting QE3 to be launched (who actually thought it wouldn’t?).

    I thought it was interesting: On Tuesday (Election Day) I read some article about how Mr. Obama had done a great job on economics, and how the rise in market values showed that. On Wednesday, markets tanked. Huh?

  10. I feel like I’ve agreed with you about something before, but I most definitely agree with this. The MR view seems lacking without an acknowledgement of human psychology, irrespective of the wealth effect.

    BB is playing the meta-policy game. He knows Congress is worthless, so he’s doing as much as possible to float the economy. The investing world seems to think QE causes inflation, so asset prices are bid up and prevent deflation (which is a big issue for physical assets).

  11. This analysis gets the causation wrong. One of the primary reasons the stock market is up is because corporate profits are up. And the primary driver of corporate profits in recent years has been deficit spending. People don’t acknowledge it, but the main reason they “feel” better about the stock market is because the govt has been spending a boat load of money that has flowed to corporate profits. I am not saying the fed has had no impact at all, but the primary cause here is the deficit. NOT the Fed. If corporate profits decline the Fed will be virtually powerless to keep the stock market up. This has been seen all over the world in various nations. There is definitive evidence that QE does not bolster corporate profits over the long-term and therefore has a muted impact on the stock market over the long-term. See Japan for instance. The Bernanke Put works in short bursts, but ultimately, the stock market always comes back to fundamentals….

    And MR explains all of this precisely.

  12. Bernanke is a buffoon. Why is congress worthless? The Federal Reserve is worthless. Take some time this weekend and read the writing of past Federal Reserve Chairman. Start with Meyer and work your way forward. You will see Bernanke in a completely different light. Nothing new here from a historical perspective.

  13. You’re wrong Romeo, JE is spot on. For the entire 3-4 years of its existence this has been a bank bailout program masquerading as a jobs program…….and because the banks never cleaned up balance sheets (fed and govt didn’t make them) they remain distressed and so QE continues even as Bernanke’s public explanations of their impact have been completely discredited. The direct purchased of said distressed assets, at face value by the way, not the 50% discounted price or more that would reflect mark to reality, is the most blatant gift. And we just keep moving along, dumbed down as ever about it all. It was only 10 years ago that enron and worldcom execs went to prison for exactly the same behavior as our govt leaders now condone on wall street. Who knew that enron and worldcom execs actually did nothing wrong….they were simply ahead of their time! krb

  14. I’m not disagreeing with what you are saying. But short term, the stock market jumps when BB announces QE. And that’s psychologically important for everyone since we have been taught for the past umpteen years to look at the stock market as indicators of our well being. Irrational? You betcha. Does it happen anyway? Yeah a little bit. And an impulse is sometimes all that is needed to change directions.

    I don’t expect MR to explain that bit. The monetary system is what it is. Gut feelings of the general population is what investing is about ;)

  15. Of course there is nothing new. Monetary policy is limited in what it can do and I do believe BB knows this. If they could helicopter money to the general population it would be different, but they can’t.

    Look at Japan for instance. The politicians are completely entrenched in the idea that monetary policy fixes all and they’ve been crabwalking for 20 years now.

  16. Don’t get me wrong. I agree that it would absolutely go nowhere without the deficit spending. HH deleveraging is just too great.

  17. Deficit spending will be higher in 2012, fiscal cliff or not, because entitlements are not touched. I don’t believe anybody seriously believes the U.S. will spend less going forward.
    So if you believe the deficits lead to higher profits, you should be all in for stocks.

  18. High productivity leads to higher profits. Credit expansion (HH or public) support the ongoing extraction of money from the consumption-production economy.

  19. Actually they started up, but then the ECB started making noise about eurozone problems.

  20. Plus of course many investors know that markets fly up after elections in the vast majority of cases so part of it might just be bringing home profits. (Idle speculation on my side, I don’t know how long these upturns typically last so I could be wrong about how long they would wait before bringing home profits)

  21. What Cullen says is the key to understand why the stock market went up (corporate profits buttressed by government deficit spending) and why it will now start going down: deficit spending can’t be sustained at the current levels. James Kostohryz had an interesting table on SA showing that the average difference between government receipts and outlays has been 3% for the last 30 years before the Great Recession. For the last three years since the recession supposedly ended this difference is 9%. This is unsustainable politically and as taxes go up and government spending goes down, the main engine behind the corporate profits will stall.

  22. Interesting point about the 5 year inflation metric. Is there a source to get that number? Thanks.

  23. To understand Fed’s policcies, you need to understand first what is the reason for the Fed’s existence and what are its priorities.

    Looking at actions (not words), the Fed is there
    1) to bail out overstretched fractional reserve banks
    2) make sure the FRL system functions properly
    3) ensure smooth functioning of govt bond markets / seignorage

    So all the Fed’s policies may seem to be aimed at the well-being of the economy, but that is just a veil of pretnce. For example the Fed does not care too much about REAL G`DP growth, because all banks need is NOMINAL GDP growth. And so on.

  24. Well, the big problem there is monetary policy, which works through the banking system. A healthy banking system is not necessarily synonymous with a healthy economy….But the Fed can really only implement policy through the banks. So….

  25. I am just not buying into the TBTF argument as a tool of blackmailing the rest of the economy and a way to cement extortion. Banks are important, but so are also…utilities. There is absolutely no need to make banks sexier (or better paid) than utilities. Even utilities are more important – what would you do without electicity and water?

  26. Seems to me that QE simply funds the deficit indirectly while providing easy profits for [institutions] holding govt bonds:

    the Fed purchase announcements raise bond prices affording banks/institutions easy profits by selling to the Fed, to simply turn around and buy the next tranche of bonds from the govt – at face value of course (ie 1 dollar for a 1 dollar bond] and now with a lower interest rate [dictated by the Feds purchase price].

    This deficit funding exercise gives banks and other institutions easy profits while they deleverage / sort out balance sheets / take losses.

    Hence the deficit spending at least stops the monetary base of the economy shrinking while the banks deleverage.

    A slower process is household deleveraging and it seems to me this cycle will continue until household debt is reduced to the point that consumption activity increases again.

    Isn’t this household deleveraging what we are waiting for?