QE3 'Rally' Will Crash Before 2013

Oct. 2.12 | About: SPDR S&P (SPY)

In my last article on the broader direction of the stock market, I pointed towards an indicator that was telling us something unsettling - the huge increases we've seen in money supply through recent years have done absolutely nothing for the actual economy.

This is shown through something known as "money velocity", which measures how much our money flows between hands (more specifically, it is the number of times that one US dollar is used per year). Money velocity (for M2) has been increasing since the mid-1960s, and spiked dramatically in the late 1990s to a high of ~2.15. Since then, money velocity has dropped below the lows made in the Vietnam War Era - to about 1.57.

The takeaway from money velocity is that, relative to our total money supply, spending has been severely depressed in the United States. Quantitative easing just resulted in the creation of huge, stagnant pools of money that are not serving any obvious purpose. They will do nothing for unemployment and the broader economy, nor do they generate substantial returns for their owners (interest rates are very low, if you haven't seen them). The only winners here are the bondholders (especially those with US treasury-bills) that are benefiting tremendously from the value of the greenback.

In a recession, Keynesian economists like Bernanke are constantly focused on the trade-off between inflation (or price level) and unemployment. Theoretically, you can actually "buy" lower unemployment with higher inflation rates - and vice versa. The problem is that certain operations, like QE3, do virtually nothing for society.

Since the Fed decided to buy mortgage-backed securities from the banks instead of T-bills, we'll never see any of these dollars enter the actual economy or buying anything useful. Even the cash given to the banks in exchange for their mortgage assets will be automatically held in the Federal Reserve itself, making the collective pool of stagnant and dead money ever bigger. Money velocity is set to drop even more at this rate, potentially making things look worse than they actually are.

There is virtually no plan of action that the Federal Reserve could have pursued that has less of an impact on the actual economy. Still, it costs $40 billion every month and allows banks to drop the annoying assets that have been crowding their attics. What do we get? Slightly lower rates on mortgages, and technically a bigger money supply.

In reaction to QE3, gold (SPDR Gold Trust ETF: GLD) showed hesitation to break records set in 2011 due to confusing inflation expectations, while silver (iShares Silver Trust ETF: SLV) outperformed by a respectable margin. The S&P 500 (SPDR S&P 500 Trust ETF: SPY) is up about 170 points since the start of June, and the Dow Jones (SPDR Dow Jones Industrial Average ETF: DIA) is up about 1500.

It's hard to determine just how much of this four-month rally in every asset class is directly related to our hopes of QE3, but we can say that it was definitely not the economic data releases that got the markets excited, because those were bad.

Stocks have not become expensive assets yet (even after our rally), but it's difficult for me to see how we can go much higher nowadays. Our optimism is completely unfounded, and we are at five-year highs, despite no obvious improvements in our economic situation.

Just last Thursday (September 27), we managed to shrug off a ridiculously big 13.2% drop in durable goods orders, and yesterday (October 1st) we've rewarded a small beat of 51.5 on ISM manufacturing with another rally!

The stock market is way too confident right now, and the psychological support offered by QE3 can only take us so far. When the market finally figures out that the $40 billion monthly cash injections will never actually be brought into the ever-weakening economy, we'll be back where we were in summer - perhaps waiting for QE4.

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.