On September 13th, the Federal Reserve announced a program in which it will purchase $40 billion of mortgage-backed securities and pursue extremely low rates until 2015. The purpose of this program is to stimulate business and help the economy recover from the malaise that has plagued the United States for the past 4 years. Through this article, I will investigate the purposes and effects of this program on the stock market as well as provide analysis as to where the market may move in the future.
The QE Infinity Pop
When the Federal Reserve announced on September 13th of this year that it would extend and expand its quantitative easing program, the markets were immediately jubilant. After all, the first and second editions of the program had propelled the stock market upwards by over 60% throughout the previous three years. In line with previous programs, the markets rallied by over 1% on the day of the announcement of the newest edition of quantitative easing. The chart below shows how the S&P 500 (SPY) has traded ever since the extension on September 13th.
It is very important to note that the markets have actually declined by nearly 5% since the Federal Reserve announced QE3. The markets have decided that quantitative easing is not an immediate solution to the monetary problems of our economy. It can clearly be seen in the chart above that the initial pop associated with new rounds of stimulus quickly faded and price began to fall.
The question that nearly every individual has is this: what happened? Unfortunately, there is no straight answer to this question. In order to answer the question of why the markets are no longer excited about quantitative easing, we would need to explore the theoretical framework behind the program itself. The Federal Reserve essentially believes that through quantitative easing it can:
- Print money
- Buy bonds
- Depress the yield curve
- Stimulate business through lower rates
Through these steps, the Federal Reserve believes that the economy will benefit both from the stimulative effect of lower interest rates and an uptick in inflation. There are many beliefs and opinions about this program, but ultimately the true and direct effectiveness of quantitative easing may never be known. There are just too many factors at work which prevent an empirical analysis of the system. For now, the only thing we can really do is attempt to understand the program and anticipate the market's response.
Since the Federal Reserve has been attempting to benefit the economy, we should turn our eyes to the data it sees when it makes its decisions.
The first economic indicator we should examine is the GDP. Gross domestic product is a strong barometer of the economy and it is essentially equal to private spending, gross investment, government spending, and the deficit or surplus.
As can be seen in the chart above, GDP has been steadily rising since the official end of the recession in 2009. Many individuals can argue that an increase in government spending has offset a decrease in private spending and investment. This is a highly debatable area, but for our analysis we should simply understand that from a GDP standpoint, things are "getting better."
Another barometer for the economy is the consumer price index. The CPI is a measure of change in the prices that consumers pay for the typical goods and services consumed by households. It is important to study CPI in that it can help us understand if prices are increasing, or if we are experiencing inflation.
As the chart above shows, ever since the trough of the recession, the CPI has been rising. This essentially means that prices are increasing for consumers, on average. Investors tend to fear inflation, however, inflation isn't that bad. The standard economist believes that increasing inflation spurs on spending since individuals are more willing to purchase something today if they believe that prices will be higher in the future. Despite the fact that this relies on an unproven economic theory, the CPI trend currently indicates that the economy is once again, "getting better."
A final economic indicator which is a bellwether for the economy is the unemployment rate. The unemployment rate is a highly watched indicator and it strongly dictates the strength of the economy.
The chart above shows the unemployment rate for the past 10 years. Ever since the economy recession ended in 2009, unemployment has steadily improved. It is important to understand that the current level is very high in relation to "normal" times, however from an unemployment standpoint, things are "getting better."
Since most of the economic indicators are pointing towards growth and expansion, why is the market falling? Well, practically speaking, the market isn't the economy! Many individuals get caught up in the notion that by understanding the economy they will somehow be better equipped to trade the markets. I disagree with this in the short run. Over the course of a few months, I believe that supply and demand of securities dictates the course of the market, not the business economy. No matter how long I examine GDP, CPI, and unemployment data, I will not be better equipped to trade the market across a short period. This said, I feel that if we are really experiencing anxiety from the recent pullback in prices, then we should put it into perspective. The economy is improving many metrics and it is safe to say that 10 years from now, your portfolio will probably be worth more than it is today. If the daily and weekly fluctuations influence your emotion state, then please examine the chart below.
It can clearly be seen that the market is in an uptrend phase which has been in progress since October of 2011. The recent pullback in prices is exactly in line with how a healthy trend should behave. In a typical uptrend, price normally pulls back to the ascending trend-line periodically. It is through these pullbacks that trend direction is confirmed. For an investor looking for a tangible market outlook, please examine the above chart and see where prices are in relation to the trend-line support. It should be obvious that we are currently at support and price may bounce and resume its uptrend in the near future.