Tuesday, May 7, 2013

Bull Story Remains Intact

Last October when the Dow was at 13300 I wrote that the effect of QE3 would become visible by the spring of this year:
“The impact of QE3 will only be felt cumulatively, as the little bits start to add up over the next six months. Six times $40B is $240B, which would represent a 9% growth in the Fed’s balance sheet, which becomes more significant--but that’s next April.”
--- “QE3's Market Impact Will Be Visible by Next Spring”, Oct. 11th, 2012

In December when the FOMC stepped up the pace and the Dow was at 13100 I wrote:
“Assuming that the Fed implements QE3 as announced Wednesday ($85B/mo), I expect to see the Dow around 15,000 next Christmas. This is because the Fed’s balance sheet should grow by $1 trillion next year, a 36% increase over where it is now.”
--“2013: The Year Of Printing Money”, Dec. 15, 2012

In March when the Dow was at 14250 I wrote:
“In December, I predicted a 15000 Dow by yearend. My current view is that we will get to 15000 by mid-summer.”
--“Stocks Will Go Higher As Reflation Gains Credibility”, March 5th, 2013

The Dow hit 15000 on Friday. I called the 2013 bull market correctly, and I did it using a single indicator: expected growth in the monetary base.

Let’s look at the facts: When the Fed began* QE1 after Lehman in late 2008, the Dow was at 8450; when QE1 ended in March of 2010, the Dow was at 11000, a gain of 2500 points, or 30%. When the Fed began QE2, in January 2011, the Dow was at 11700; when QE2 ended in July, the Dow was at 12850, a gain of 1150 points or 10% in six months. When the Fed began QE3 in late December, the Dow was at 13000; four months later the Dow is at 15000, a gain of 2000 points or 15%. Since the Fed began its QE policy, the Dow has risen from 8450 to 15000, a gain of 77%. Lesson: Don’t fight QE.

It appears that there is (in the current macro-environment) a positive relationship between the size (or growth rate) of the Fed’s balance sheet and the market value of the Dow stocks. Explaining this relationship can be complicated, but here is mine (or, rather, Scott Sumner’s): the Dow reflects expected nominal growth. Nominal growth increases corporate profits which makes stocks more valuable. QE increases nominal growth if pursued with sufficient vigor.

Is there some econometric rendering of this relationship? I wouldn’t know, but it looks to me to be more directional than proportional. The mediator is of course the two velocities: the M2/MB ratio**, and the GDP/M2 ratio, both of which have been falling, thus requiring ever greater doses of QE.

I said that my predictive tool is expected growth in MB, but perhaps I should really say expected nominal growth (or maybe I should say the expected real short-term interest rate). After all, growth in MB in and of itself doesn’t make companies more profitable; what makes companies more profitable is growth in nominal GDP (the product of M x V).

When I say “in this macro-envirnonment”, what I mean is “when inflation expectations are very low”, such that the market interprets growth in NGDP to be mostly real. It would have been a different story in the seventies, when the Fed had no credibility and expected nominal growth would have been discounted as inflation.

Since QE3 began, the MB has been growing at about $100B/month or 40% annually. The plan is to maintain this pace at least until unemployment falls another 1% to 6.5%. The credibility of this commitment is less than 100%. Everyone knows that there are committee members who want to stop it now; and everybody knows that Bernanke is a lame duck.

Therefore, the market has not fully incorporated (in my opinion) the announced employment target. Any signal of hesitation by the FOMC would cause the rally to stop. The stock market has no basis for optimism about Fed policy after this year, when Bernanke will be replaced by a weaker, less authoritative person. But for now, Bernanke is in charge, the employment target has been repeatedly stated, and QE3 is going full bore.

There is, however, one worrisome datapoint: inflation and NGDP growth are falling, because velocity continues to decline (from 2.1 in 2000 to 1.5 now). If this is not a blip, this means that the Fed will need to step up the pace in order to hit its employment target. Monetarists have been saying that the Fed should vary the pace of QE in order to stay on track. The Fed appeared to concede this point last week when it said: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” I hope they really mean that.

Investment Conclusion
The conditions for rising equity prices remain in place as QE3 continues (or  accelerates). The equity risk premium still favors stocks over bonds (which are highly risky at this point in the epicycle). Cash remains penalized, forcing the risk-adverse to creep back into the equity market. A crucial piece of market information will be the identity of Bernanke’s successor.***
*M2 = the money supply; MB = the monetary base, the Fed’s balance sheet; V = velocity, the ratio of GNP/M2.
**I date the periods of QE based on the movement in the monetary base, not the FOMC statements.
**One can only hope that the Republican hard-money caucus does not prevent another dove, such as Janet Yellen, from being confirmed.

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