If one looks at the market's reaction each time the Fed or any other central bank hints that some new, "unconventional" form of easing may be just around the corner, it would be easy to conclude that central banks have been successful in stimulating the economy. Once one observes the market's response to the release of various economic data, however, the waters become a bit muddy. Presumably, the market cheers QE and other central bank action because such action is expected to benefit the economy, and thus, set the wheels in motion once more so that things can run smoothly on their own (i.e. without the constant intervention of policymakers).
But when the market rallies on bad economic news, it becomes apparent that stocks are, in fact, rooting for the economy to perform poorly so that the likelihood of more central bank intervention increases. Of course, this is putting the cart before the horse. That is, the market shouldn't hope for bad economic news because such news would prompt the Fed to act when the whole reason for the Fed's action in the first place was to improve economic conditions. To do so seems perverse.
But when one looks at the evidence, the picture becomes much more clear, and the rationale behind the market's behavior becomes quite obvious. The following chart shows global growth, and marks significant instances of fiscal and monetary stimulus:
(click images to enlarge)
Chart: Bridgewater Associates
What is striking about the chart is that clearly, central bank action is having less and less of an impact on growth. Specifically, each time efforts are made to provide stimulus, the positive effect is less pronounced.
Now, take a look at the chart below, which shows the performance of the S&P 500 over the same time period and with the same points of fiscal and monetary stimulus marked:
Clearly, U.S. stocks have benefited more from central bank action than global growth has. The overall trajectory of the S&P 500 since the end of 2009 is emphatically up with only one significant retracement (during the fall of last year following the S&P downgrade of the U.S.), while the overall trajectory of global growth since the end of 2009 is down, with a few periods of recovery following monetary and fiscal stimulus.
The message is clear. The tools that central banks have employed are becoming less and less effective at stimulating global economic growth, but have largely retained their ability to positively impact U.S. stock prices. It is no wonder then, that the stock market sometimes cheers when economic data is weak. A recovery means no more stimulus, which might jeopardize the rally. But this is a terribly precarious scenario.
This has the potential to create a situation wherein the Fed and its international counterparts continue to implement monetary and fiscal stimulus in increasingly dramatic fashion as part of a desperate attempt to squeeze whatever positive returns they can from an increasingly unresponsive global economy. For instance, Eric Rosengren, president of the Federal Reserve Bank of Boston, recently recommended indefinite and "open ended" QE. Meanwhile, the stock market continues to respond just as favorably as it has before.
In the end, central banks' return on investment (i.e. the growth they can squeeze out of the economy by printing more money) falls to zero as stocks hit new highs. This sets the market up for a far more dramatic fall than would have otherwise been the case if the central banks of the world had simply ceased to implement policies that clearly are not working. Instead, these organizations should allow the world's economies and markets to reach equilibrium naturally (and yes, "naturally" might entail sovereign defaults).
Alas, it is not the intention of central planners to allow this to happen. As such, more money will be printed and positive returns measured by global growth will continue to diminish and approach zero. The stock market cannot sit atop this house of cards forever. I recommend positioning for a decline via a short position in the S&P 500 (SPY) or, alternatively, going long volatility.