S&P To 1872 From Quantitative Easing

Includes: SPY, UPRO
by: Macro Investor

Ever since the Dow broke the 14,000 mark and the S&P broke the 1,500 mark, even in the face of a shrinking GDP print, a lot of investors and commentators have been anxious. Some are proclaiming a rocket ride to the moon as bond money now rotates into stocks. Yet others are ringing the warning bell that this may be the beginning of the end, and a correction is likely coming. Barron's reports both sides of the coin:

On the bull side, we have the trailing P/E argument

Can it go higher? ... the S&P 500 is just slightly below its all-time high of 2007, even as the index's trailing annual earnings per share are about $100, versus $85 in 2007.

On the bear side, we have trouble in DC:

What could dampen the party, near-term, are the talks in Washington about government spending and the March 1 sequestration deadline.

On Monday, the news of some political challenges faced by the Spanish Prime Minister Mariano Rajoy was enough to cause a market sell-off, which I found somewhat amusing. This is why I find it a bit surprising that no one is talking of the single largest driver for stocks in the past 4 years, massive monetary base expansion by the Fed.

US Monetary Base Chart

To estimate the monetary base expansion on the S&P 500, I did a simple calculation. Projecting the monetary base in the future is tricky, so I took the Federal Reserve Balance Sheet as a proxy. I plotted the S&P 500 (NYSEARCA:SPY) against the Fed's Balance Sheet on a weekly basis since the market bottom on March 2009.

Click to enlarge

From the chart, it is clear that the Fed's balance sheet is a good proxy for the monetary base. I ran a regression model to see how the S&P 500 has changed with the Fed's balance sheet.

Click to enlarge

The R2 at ~77% is pretty high, which means that 77% of the price movement in the S&P 500 can be explained by changes in the Fed's balance sheet. Can this model be used to predict where the S&P 500 will be at the end of 2013? We know that the Fed will be expanding its balance sheet by at least $85 billion each month from QE, which means the ending balance will be ~$4T. Substituting in the equation, this means a end year value of SPY of ~187, or a S&P 500 of ~1872, which means a 25% increase from current levels. If QE was to continue for 12 more months in 2014, the end 2014 value of SPY would be 239, or a S&P 500 of 2387, which means a 60% increase from current levels by end of 2014, or another 28% increase in 2014.

This may seem like big increases, so let's cross check this with historical P/E ratios. Even if earnings were to be flat for the next 12 months, at 1872, S&P 500 will have a backward looking P/E of 19. If earnings were to increase by 5%, backward looking P/E would be 18, and if they were to increase by 10%, backward looking P/E would be 17. As a comparison, the last time the S&P 500 was at 1500, the backward looking P/E was 17.6. So these numbers are not unrealistic at all.

So, how can an investor profit from this trend? Today, I bought January 2014 strike 115 calls on the 3x leveraged ETF on SPY (NYSEARCA:UPRO) for $11.5. If the S&P increases by 12.5% from this level (half of the predicted 25%), then UPRO will end the year at ~140. This will mean about 120% return on the calls in a year. Breakeven will require about 7-8% increase in the S&P 500, which I expect to come before summer.

This market, fueled by massive amounts of liquidity being pumped by the Fed, has legs.

Disclosure: I am long UPRO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also hold UPRO calls.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice.