In several recent articles in these pages, Colin Lokey reprised arguments from Zero Hedge that the stock market is being artificially supported by bank proprietary trading, funded by a flood of money from Federal Reserve quantitative easing ("QE"). Lokey's conclusion is that recent gains are built on hot money flows and are therefore unsustainable.
This article expands on Lokey's argument, zeroing in on the effect of QE on the growth in margin debt, and supports the conclusion that the ongoing flow of Fed asset purchases will not be as positive for stocks (SPY) in the short run as many believe.
Stocks and the Fed's Balance Sheet
It is no secret that the Federal Reserve has expanded its balance sheet massively since the financial crisis erupted to try to support economic growth and asset prices. Through large-scale purchases of Treasury securities, mortgage-backed securities and a laundry list of other assets, the Fed's balance sheet expanded from $925 billion in assets at the beginning of 2008 to $2.97 trillion at the beginning of 2013.
The following chart shows a breakdown of the liabilities and equity side of the Fed's balance sheet to show where the money from these asset purchases has gone. While the Fed has continued to steadily increase the supply of Federal Reserve Notes (e.g. currency) in the economy, the vast majority of the funds related to quantitative easing have ended up in the banking system, as evidenced by the sharp increase in the "Deposits Held By Depository Institutions" category (see the purple shaded area in the chart below).
These deposits consist of the Required Reserves that banks must hold with the Fed, which grew by $70 billion between the end of 2007 and the end of 2012, and Excess Reserves, which grew by $1.46 trillion over the period.
It is crucial to note that Excess Reserves of Depository Institutions on the Fed's balance sheet do not represent "unproductive cash parked at the Fed," as some believe, but instead resources that the banking system as a whole can use to make loans or purchase securities and other assets (read Antinolfi and Keister of the Federal Reserve Bank of New York for more information).
Data supports Lokey's argument that these resources have been making their way into stocks. The steady increase in excess reserves since 2008 has a 0.84 correlation with the S&P 500 index during that period (see chart below). Indeed, the trend in excess reserves has seemed to lead the S&P 500 at several key points (more on that later).
Margin Debt and Excess Reserves
Lokey - and Zero Hedge before him - described a link between quantitative easing and bank proprietary trading. Margin lending to hedge funds and other investors may be another means by which quantitative easing is transmitted to stock prices.
Total margin debt - or debit balances in margin accounts reported to FINRA by both NYSE and NASD brokers - has been strongly related to the overall path of the stock market. Indeed, the sharp increases and decreases in margin debt seems to amplify market swings during cyclical bull and bear markets (see chart below).
While margin debt has rebounded by over $150 billion since February 2009 - to just over $350 billion at the end of November 2012 - it has still not come close to the high of over $400 billion in July 2007. When looked at as a percentage of Gross Domestic Product, as well, total margin debt is elevated compared to a longer history but does not seem unduly influenced by the Fed's recent balance sheet expansion (see chart below).
However, comparing the path of NYSE margin debt with total monthly turnover (in millions of dollars) on the New York Stock Exchange begins to paint a different picture. After being closely related to total turnover from 2004-2008, margin debt began to diverge, steadily increasing while monthly trading turnover fell (see chart below).
As a result, the ratio of the amount of margin debt to total monthly turnover rose from between 10-15% to over 30%. This increase in the prevalence of margin debt, which was funded by the banking system and likely has supported stock prices over that period, has an almost 70% correlation with the increase in excess reserves over the period (see chart below).
So, if quantitative easing adds resources to the banking system - and these resources make their way into the equity markets, supporting prices - isn't "QE-infinity" a good thing for stocks in the short run? Not necessarily.
The following chart plots the one-year change in "Other Deposits Held by Depository Institutions" (mostly excess reserves) versus the future one-year S&P 500 price return. Since January 2009, the change in excess reserves has exhibited a strong positive correlation (0.503) with the future one-year return and a strong negative correlation (-0.577) with the previous one-year return (see chart below).
This implies that Fed quantitative easing supports stock prices with a lag and that the time to buy stocks may not be when excess reserves are just beginning to grow on a year-over-year basis, as they are now, but instead when balance sheet expansion has had more of a chance to filter into the banking system. Early 2009 obviously provides a counterpoint to this argument, as prospective one-year returns and excess reserves increased simultaneously. The lack of an immediate impact more recently may be explained, though, by the declining marginal utility of each round of Fed easing. In any event, the data do not suggest, as some strategists have, that the latest round of quantitative easing will be an immediate boon to the stock market.
But what of Lokey's argument that the cyclical bull market in stocks since 2009 is a house of cards, built completely on the sand of quantitative easing, and is vulnerable to a collapse once easing is taken away? To the extent that the increase in excess reserves has added to margin debt - particularly among hedge funds - I tend to agree with him. The "de-margining" of highly-leveraged investors creates a vicious and volatile feedback loop that can turn a normal market correction into a more serious crash. This does not mean, though, that margin and stocks cannot push still higher in the medium term as excess reserves grow. Substantial further gains, though, would increase the risk of negative herding, de-margining and a critical event.
As I have mentioned in previous articles, I believe that using a trend-following risk-control strategy for core holdings and adding a momentum strategy - which performs relatively well during "bad times" - to diversify sources of return can be an appropriate way to position for double-sided risks.