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A short while ago I saw the chart below somewhere and it caught my attention. However, because it was not a Saint Louis Fed chart, I followed the explanation of the chart from the article and built it from scratch myself to double-check it was correct.

Sure enough, using the data from the Saint Louis Fed and following the explanation, I was able to perfectly duplicate the original chart I saw.

(click to enlarge)

Let me explain what the above chart is.

The blue line plots the total value of mortgage-backed securities held by the Federal Reserve (all maturities), plus the total U.S. Treasury securities held by the Federal Reserve (all maturities), and the red line on the chart is the S&P 500 index (NYSEARCA:SPY).

In essence, this chart tracks the Fed's quantitative easing policy vs. the performance of the S&P 500 index. And as most people observe, the performance of the S&P 500 index is almost a mirror image of the Fed's asset purchases.

So this leads me to certain conclusions:

1) If the Fed tapers in any way, the S&P as well as the Nasdaq (NASDAQ:QQQ) and the Dow Jones Industrial Average (NYSEARCA:DIA) will correct, as will many other assets like housing (NYSEARCA:XHB) (NYSEARCA:ITB). For example, if the Fed stops buying mortgage backed securities, then it is more than likely that interest rates on housing loans will go up.

2) Because the Fed also has the same data (and many other sets of data that probably lead to the same conclusion), the Fed is terrified of what would happen if it stopped purchasing assets. And since we are all in uncharted waters, it is afraid to stop QE, fearing that the market will correct by a lot and that will put an end to its asset inflation policy that is largely responsible for helping the U.S. Economy out of the last recession.

3) If the previous two observations of mine make any sense, that also means that the Fed will continue to buy assets indefinitely, or until it figures out a way to stop QE without causing havoc. But because the Fed has not figured out a way on how to do that yet, my conclusion is that they will continue with QE for the foreseeable future.

Not wanting to get into a philosophical debate on whether asset purchases are good or not, what is clear from this chart is that as long as the Fed continues with these purchases, chances are that the S&P 500 index will continue upwards.

So what should investors keep their eyes on?

1) If the Fed tapers, the market will correct, but probably not by a whole lot. Markets will initially correct but will find support somewhere lower.

2) If however the Fed stops asset purchases altogether, then U.S. markets will initially correct by at least 15% and a top will probably have been formed.

3) However if the Fed decides to unwind its balance sheet, I am convinced that this will cause havoc in financial markets. Even the mention that the Fed wants to unwind will shed at least 25% off the S&P in a matter of months. Please note on the top chart that when the Fed in 2008 shrunk its balance sheet by a little, that took off 50% from the S&P. I think it will never try that again.

As for gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) and commodities in general, since QE has not helped to support the price of gold or silver, if the Fed tapers, they will also correct.

However most commodities are neutral to Fed action because they are a function of real world demand and supply. But in the case of gold and silver, we also have the investment element.

So in the unlikely event that the Fed decides to unwind its balance sheet, then both silver and gold will crash. By how much we will see when the time comes, however I think that the $1,000 mark in gold will be very easy to breach.

Source: The S&P 500 Index Trapped In QE