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The Correlation Between Stocks and the Fed

Should there be any question as to what undergirded the strength in the stock market over the past few years this chart (see below) seems to clear the matter up quite succinctly. The massive expansion of the Federal Reserve’s Balance Sheet to essentially provide an ongoing bailout of the economy has overshadowed the correlation of almost all other measures of corporate and economic health. Translation: Stock market prices may be divorced from underlying economic health and corporate growth and dependent instead on Federal Reserve intervention. Is this healthy or sustainable? Where does this type of path lead us?

I would liken the Fed’s action to administering ever increasing doses of drugs to help an addicted patient avoid withdrawal symptoms. We would not celebrate a patient’s need for ever-increasing doses of drugs to offset the pain and life threatening effects of severe withdrawal. Nor would we rejoice in the temporary relief the patient experiences as the symptoms subside due to the increased presence of drugs in their system. Why then do the economic pundits cheer the actions of the Fed for the past several years? It would be one thing if the balance sheet had been wound down and the correlation between Fed intervention and stock prices had subsided. However, the opposite is the case. The Fed’s balance sheet has never been larger, nor have they ever embarked on a program to infuse so much leverage and potential inflation into the system on an ongoing, indefinite basis.

The Federal Reserve’s intervention is likely creating a dependency, a dependency on which the markets may not be able to live without the longer it is maintained. The fact that economists and pundits now widely expect and, in some cases, demand Fed intervention on a regular basis whenever the market swoons shows the level to which Fed intervention may have perverted the concept of a healthy, functioning market. This would be reflected as well in the price action of the markets as they invariably march higher with each announcement of quantitative easing. Wouldn't the prudent perspective view each round of quantitative easing as a clear admission of the economy's fragile state and dependence on intervention to prop up a severely weakened market?

On one hand, perhaps the Fed’s intervention saved us from an even deeper recession or depression and they will be able to successfully unwind their balance sheet and let the markets take over as the economy eventually recovers. This is still a possible, but unlikely outcome as is evidenced by the failure for the economy to respond thus far. On the other hand, the Fed could be crippling an economy by creating dependence on easy money that is ultimately borrowing from the future to produce a lackluster present. The Fed’s actions could be setting us up for an even greater crash if their interventions become ineffective. Just like certain drug addictions, if the drug doses get too large and are administered too often, the body becomes so dependent on the underlying drug that the patient may not actually survive an eventual withdrawal at any material level.

It seems self-evident that just as ongoing administration of ever increasing drug doses is not a sustainable path, the Fed’s current path of pumping vast amounts of leverage and synthetic demand into the system cannot be sustained indefinitely. The timing of the intervention is especially troubling given that we will be in a recession again, eventually, and may have need for an intervention that has already been administered. Now that the Fed has already launched QE “Infinity” for an extended and indefinite period of time, what on earth will they launch to offset the next cyclical downturn?

...To Infinity and Beyond.

Written By: Joshua Ungerecht

Correlation, Federal Reserve, Quantitative Easing, S&P 500