SPY, MDY And IJR At The Fed's QE3+ Market Top

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 |  Includes: IJR, MDY, SPY
by: J.J. McGrath

Summary

The share prices of the three exchange-traded funds tracking the S&P Composite 1500’s constituent indexes all have rocketed higher since the announcement of the U.S. Federal Reserve’s current quantitative-easing program.

Between Sept. 12, 2012, and March 7 of this year, the large-capitalization SPY soared 34.67 percent; the mid-capitalization MDY, 40.45 percent; and the small-capitalization IJR, 46.03 percent.

The across-the-board increases in share prices came as each of the three ETF pairs (i.e., SPY-MDY, MDY-IJR and SPY-IJR) went from strong positive correlation to almost-perfect positive correlation.

There are also almost-perfect positive correlations between the levels of each ETF and the values of the Federal Reserve Bank balance-sheet assets at this point in the Age of QE3+.

As the Fed acts to conclude its latest adventure in experimental policy, one is compelled to compute estimated SPY, MDY and IJR share prices at the QE3+ market top.

Share prices of the SPDR S&P 500 ETF (SPY), SPDR S&P MidCap 400 ETF (MDY) and iShares Core S&P Small-Cap ETF (IJR) all have been driven higher by the U.S. Federal Reserve's current quantitative-easing (QE) program, which was announced after a Federal Open Market Committee (FOMC) meeting on Sept. 12-13, 2012.

Their across-the-board advances have been associated with other distortions in the market, as well. For example: In their relationships with each other, the three exchange-traded funds tracking the S&P Composite 1500's constituent indexes behaved one way before the announcement of QE3+ and have behaved another way since then.

I call the Fed asset-purchase program now under way QE3+ because FOMC under its auspices authorized first the buying of agency mortgage-backed securities and then the buying of U.S. Treasury securities. (Of course, the QE1 and QE2 asset-purchase programs both were more or less completed by the time of SPY's 2011 bear market, when on an intraday basis the ETF dipped to $107.43 on Oct. 4 from $137.18 on May 2, a drop of $29.75, or 21.69 percent. Coincidence? I suspect it was not so.)

Figure 1: The 3 ETFs' Strong Positive Correlation Before QE3+

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Source: This J.J.'s Risky Business chart is based on Yahoo Finance adjusted daily share-price data.

Before the announcement of QE3+ (i.e., from May 26, 2000, to Sept. 12, 2012), there were strong positive correlations between SPY and MDY and between SPY and IJR, as well as an almost-perfect positive correlation between MDY and IJR. This appears logical because equity-market participants historically have differentiated between larger-cap stocks and smaller-cap stocks.

Figure 2: The 3 ETFs' Almost-Perfect Positive Correlation Since QE3+

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Source: This J.J.'s Risky Business chart is based on Yahoo Finance adjusted daily share-price data.

Since the announcement of QE3+ (i.e., from Sept. 12, 2012, to March 7 of this year), there have been almost-perfect positive correlations between SPY and MDY, between SPY and IJR, and between MDY and IJR. This seems illogical because equity-market participants historically have differentiated between larger-cap stocks and smaller-cap stocks.

Figure 3: SPY And Federal Reserve Bank Assets In The Age Of QE3+

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Note: The SPY share price and FRB assets are reported here on a weekly basis as they were on Wednesdays during the relevant period.

Source: This J.J.'s Risky Business chart is based on FRB balance-sheet data at the Federal Reserve Economic Data (NASDAQ:FRED) site hosted by the Federal Reserve Bank of St. Louis and SPY adjusted daily share-price information at Yahoo Finance.

During the Age of QE3+, SPY has advanced to $188.26 from $139.79, a gain of $48.47, or 34.67 percent. Over the same period, assets on the consolidated Federal Reserve Bank (NYSE:FRB) balance sheet have ballooned to about $4.17 trillion from about $2.82 trillion, an increase of about $1.35 trillion, or 47.75 percent. At the same time, there has been an almost-perfect positive correlation between the level of the ETF share price and the value of FRB assets. It is true correlation does not imply causation, but it is also true the former does serve as evidence of the latter in a number of cases. And I would argue that this is one of those cases.

Figure 4: MDY And Federal Reserve Bank Assets In The Age Of QE3+

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Note: The MDY share price and FRB assets are reported here on a weekly basis as they were on Wednesdays during the relevant period.

Source: This J.J.'s Risky Business chart is based on FRB balance-sheet data at the FRED site and MDY adjusted daily share-price information at Yahoo Finance.

During the Age of QE3+, MDY has advanced to $253.00 from $180.14, a gain of $72.86, or 40.45 percent. Meanwhile, there again has been an almost-perfect positive correlation between the level of the ETF share price and the value of FRB assets.

Figure 5: IJR And Federal Reserve Bank Assets In The Age Of QE3+

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Note: The IJR share price and FRB assets are reported here on a weekly basis as they were on Wednesdays during the relevant period.

Source: This J.J.'s Risky Business chart is based on FRB balance-sheet data at the FRED site and IJR adjusted daily share-price information at Yahoo Finance.

During the Age of QE3+, IJR has advanced to $112.12 from $76.78, a gain of $35.34, or 46.03 percent. At the same time, there again has been an almost-perfect positive correlation between the level of the ETF share price and the value of FRB assets.

SPY, MDY And IJR At The Fed's QE3+ Market Top

Prediction is very difficult, especially about the future, according to the likes of Niels Bohr and others. Accordingly, I will not be making any with respect to the share prices of SPY, MDY and IJR at the Fed's QE3+ market top. However, I have calculated estimates of how high each of the three exchange-traded funds tracking the S&P Composite 1500's constituent indexes could rise before reaching their respective long-term inflection points, employing data associated with QE3+ alone.

Because these estimates are grounded in my analyses of data associated with QE3+ only, they may not appear reasonable to you but might seem reasonable to me. There are multiple forces at work in the equity market at any time, so it is possible I could be overweighting the effects of the Fed's monetary policies in general and its QE3+ policy in particular as they influence the movement of the stock market. Not probable but possible.

Moreover, these estimates are subject to wide margins of error for a number of reasons, including the following three:

  • FOMC has indicated its course is not preset with respect to QE3+. The committee first announced it would cut its monthly asset purchases to $75 billion in January from $85 billion in December, and it then said it would trim them to $65 billion in February from $75 billion in January. And many financial-market participants anticipate it would continue its reductions at a similar pace this year. However, FOMC may not do so, especially given the recent slowdown mentioned in "SPDR S&P 500 ETF Rises As U.S. Economic Index Falls."
  • The equity market is already overvalued, as Doug Short noted in his "Market Valuation Overview: Still Expensive" at Advisor Perspectives. Accordingly, there is little or no reason for SPY, MDY and IJR (or their underlying indexes) to rise from their respective current levels based on valuation.
  • Speculation in the stock market is either at or close to an all-time high, as I pointed out in my "NYSE Margin Debt Reaches Record $451.30 Billion In January, With Risk Rank At No. 10." As a result, there could be sooner or later a dramatic turn in money flow, to outward from inward.

With these caveats in mind, my calculations using data associated with the Age of QE3+ suggest long-term peaks could be attained by SPY in the area of $197.36, MDY in the area of $267.93 and IJR in the area of $119.74. As a growth-and-value guy, I find these figures kind of nuts, but, hey, they fit hand in glove with the way we live now: Don't fight the Fed.

Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author's best judgment as of the date of publication, and they are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.