Are There Ethical Implications To The Fed's Self-Proclaimed 3rd Mandate?

| About: SPDR Dow (DIA)
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For some time now there has been a divergence between stock prices and the economy but this week's data on the economy and the price action of the stock market were particularly disconcerting. For the first time in 3½ years GDP turned negative and the unemployment rate moved back up a tenth of a point to 7.9% while stocks forged higher.

Despite these disappointing numbers the Dow (NYSEARCA:DIA) surged to post recession highs on the week closing at 14,009. The last time the Dow was at these levels was October of 2007. In that month unemployment was 4.7% and real GDP was $13.270 trillion. Today unemployment is at 7.9% and real GDP is at $13.647 trillion.

One could take some solace in the fact that at least the GDP number is slightly higher today if it weren't for the fact that the reason it is at these levels is due to a government subsidy to GDP of $1.45 trillion a year on average for the last 4 years - that subsidy being the amount of the deficit-financed fiscal stimulus money that has been pumped into the economy.

One must also consider the fact that our national debt in October of 2009 was $9.007 trillion compared to a debt in December of 2012 of $16.432 trillion. We had a budget deficit of $236 billion in 2009 compared to a budget deficit in 2012 of $1.059 trillion.

As a side note I am not sure how the government arrived at the $1.059 trillion since we effectively ran out of money in December of 2012 and that implies that we used the full measure of the 2011 debt ceiling increase totaling $2.1 trillion in 17 months. A little simple math suggests that the real deficit averaged $123 billion a month since August of 2011 and that works out to $1.476 trillion a year.

One can argue that stocks tend to price in future expectations and therefore the Dow at 14,000 is reasonable. I don't think anybody really thinks that is the case though. What I think the stock bulls believe is that the Federal Reserve will continue to prop up stocks with very aggressive monetary policy and that is exactly the point of this article.

I think one thing we can all agree on is that the Fed has made a concerted effort to force money into stocks. Bernanke's "wealth effect" is and has been in full play since the start of QE1. The logic goes like this - if the people's 401K's are growing it will create a "feel good" effect motivating them to borrow and spend and that will drive GDP which in turn will drive demand for labor and unemployment numbers will move back to more normal levels.

The problem is this - it hasn't worked. All Bernanke has managed to do to date is drive stocks and bonds to artificially high levels when compared to the broader economic metrics such as GDP growth and unemployment. The Fed has two mandates - full employment and an inflation rate somewhere in the 2% range. The Fed has no mandate to create a bubble in stock and bond prices but that is what they have done.

Out of curiosity I decided to look into this matter a little and see just how much impact the Fed's monetary policy has had in pushing stock prices higher. The following chart shows that the Fed balance sheet expansion and the DJIA had a correlation coefficient of .90.

By the way I have seen other versions of this same chart showing the S&P price movement in context with the start and stop of each new policy initiative but I haven't seen one where the actual Fed balance sheet additions were incorporated into the chart. By just looking at the start and stop points of the various QE's and "Twist" one can reasonably assume that stocks have risen solely on the speculative bets of the public but when adding the Fed balance sheet additions to the chart and looking at the correlation one can reasonably assume that the Fed's newly printed money is in fact the driving force behind stocks.

To build the chart I took the 3 week moving average of the Fed's balance sheet additions and the 3 week moving average of the DJIA. I overlaid the start and stop point for each of the QE's and the "Twist" program. Series 1 above is the Fed' balance sheet additions; Series 2 is the DJIA; series 3 is the duration of the QE's; and series 4 reflects the "Twist" program.

I'll admit I was astonished at the correlation and also very disturbed. There are implications here that suggest the Fed has taken on a 3rd mandate and that the Fed's money printing is flowing directly into stocks. That also suggests the Fed has some co-conspirators in this effort. After all the Fed doesn't buy stocks.

There are a few who offer what I consider to be a very valid thesis on how the Fed has accomplished this phenomenon. Colin Lokey has written a 3 part series (here, here and here) on the matter and if I understand his premise he is of the opinion that when the Fed buys securities from banks through QE's those banks then buy new securities which they then hypothecate to third parties and use the cash from this to buy stocks in off balance sheet transactions thereby circumventing the intent of the law if not actually violating the law.

If this is in fact going on then it does have some very serious ethical implications not to mention the legal and fiduciary implications of making stock market bets with depositor monies. To those implications in a minute but once again take a close look at the chart above. Each time the Fed's purchases stopped the DJIA fell back and each time a new initiative was started and new purchases commenced the DJIA regained its losses and headed higher in lock step with the Fed purchases. There was almost no lag time between the new infusion of money and the surge in the DJIA.

The single anomaly here is the August, 2011 crash precipitated by the debt ceiling debate and the subsequent credit downgrade. It does appear that stocks moved up during this period based on the public's speculative bets arising from the "Twist" program being announced as the Fed's balance sheet additions were pretty much flat during that period.

With that one exception the DJIA didn't move up ahead of the cash infusion nor did it lag but instead it moved almost instantly as new money was made available. I'm sure there are many who don't find this particularly profound as most market participants know the Fed's policy is the only reason stock prices are moving higher but I don't think very many of these stock participants really believe the Fed is actually orchestrating the process through a cleverly devised scheme in concert with a handful of major money center banks.

Additionally there is support for this thesis in the market's positive response to negative data over the last several weeks. The Fed has increased its balance sheet from Dec. 12 to the end of January by $140 billion (perhaps in anticipation of the need to provide fuel for stock market support as we entered the contentious issue of the "fiscal cliff). That tends to explain what seems to me inexplicable based on a number of matters that should have moved stocks lower in the last 30 days:

  • The "fiscal cliff" debate.
  • The fact that the matter of the "fiscal cliff" was not resolved.
  • The termination of the payroll tax holiday negatively impacting GDP by $125 billion
  • The "sequestration cuts" that should kick in at the end of February that the CBO projects will negatively impact GDP by about $109 billion in 2013.
  • The fact that GDP turned negative for the first time in 3 ½ years.
  • The fact that unemployment once again ticked up.

What matters as a trader or an investor is whether or not this can continue. It is particularly disturbing and not at all a good thing when the stock market moves higher on bad news. It creates a complacency that is dangerous and it induces traders and investors to jump on the band wagon in hopes that the Fed will be able to keep a floor under stocks regardless of the economic metrics that suggest the markets should move much lower.

Just such a situation has occurred in January as money inflows have been impressive suggesting that the public is finally coming back into the markets. Whether or not this turns out to be a good thing depends on how effective the Fed is at keeping a floor under the markets. The mode of operation in the last 45 days is for somebody -- very possibly the money center banks -- to buy negative news to offset the downward pressure from those electing to do the reasonable thing and sell the market on that negative news.

So far so good as the buying power has managed to offset the selling pressure most probably because we have become accustomed to moving higher on negative news and therefore not that many traders and investors elect to react to the negative data. One wonders how long this can continue or whether the money provided by the Fed will be sufficient if a sudden surge in selling occurs.

The Fed's $85 billion a month is a pretty impressive sum to work with but is it enough to fade a heavy volume sell off? Consider that the Dow stocks volume on Friday was 609,270,705 and the average price per share is about $60. That means that roughly $36 billion in DJIA stocks changed hands on Friday. This would suggest that perhaps there is enough money to fade a major sell off on DJIA stocks for a few days and that has been long enough to deter the sellers - so far at least.

In normal times the thesis set forth here would be summarily dismissed and rightfully so but these aren't normal times. I do believe the Fed is more directly connected to what can only be construed as market manipulation than many believe. I can even see how such involvement in a scheme of this nature could be rationalized and justified to some degree.

However, if my premise is correct it is nothing more than an attempt to corner the market and force it in a direction that is not consistent with the broader economy. As a 40 year veteran of the markets I have never witnessed a successful corner. Perhaps the most infamous attempt to corner a market was the silver market of 1979-80. The Hunt brothers of Texas were reported to have had control of 1/3 of the total silver supply in circulation at one point. The chart below shows the outcome on this particular attempt to corner a market.

On a personal note I chased that market back in 79-80 riding it all the way to the top and most of the way back to the bottom. The results were devastating and I've never tried to chase an irrational bull market since that date.

Concluding thoughts

As those who follow me know I am not at all optimistic about stocks for 2013 and do expect a major sell off and a test of the 2009 lows. That pessimism is based on a long litany of negatives that I believe will end up pushing us back into recession in 2013. The recent spike up in unemployment and the downturn into negative territory on GDP tend to support my conclusions in this regard.

To date these negatives have had almost no impact on stocks and one must take into account the determined efforts on the part of the Fed to fulfill their self proclaimed 3rd mandate of keeping a floor under the US stock market. The question is can they do it and will they do it?

There are a multitude of possible scenarios to consider. The Fed must consider just how far they want to take this policy. As we approach all time highs the playing field necessarily changes in that we now have a very clear reference point. In other words we can compare economic metrics today with the last time we were at these levels and ask if we are better off today than we were then.

The answer to that question is that we most definitely are not better off and in fact much worse off as we have been able to stay in positive territory on GDP only through massive fiscal stimulus that has reached unsustainable levels. We are beginning to experience the effects of the "Law of Diminishing Returns".

Few seem willing to consider that a good portion of the "fiscal cliff" really wasn't avoided. The total of all the "fiscal cliff" tax hikes and spending cuts were in the $600 billion range but consider that most estimate the payroll tax increase that went into effect in January is in the $125 billion range. Additionally, the "sequestration" cuts seem on track to go into effect at the end of February and the CBO estimates that will negatively impact GDP by $109 billion.

That is $234 billion and represents about a 1.5% contraction to GDP for 2013. As the impact of these reductions in GDP become apparent in coming weeks and considered within the context of all time highs on the major stock indices and an economy that has already turned negative one wonders how long it will take for traders and investors to come to their senses.

It would seem the Fed can fade the negative news and keep stocks propped up but one must wonder what happens when market participants finally lose faith as they surely will if the economic data continues to be negative. If sentiment shifts the Fed won't be able to stop a sell-off. $85 billion is a lot but it won't be enough in the end. When that happens or what ends up being the catalyst is anybody's guess but the harsh truth is that we are not better off today than we were the last time we were at these levels and the crash in 2008-09 is still fresh in investors minds.

I will close with this - no attempt to corner a market that I know of ever ended up working in the end and only served to make the markets overshoot to the downside when the bubble finally burst. The Great Recession was the result of a government sponsored debt crisis in the housing market and our resolution to the problem has been even more of the same - massive accumulation of debt. The Federal Reserve is not omnipotent as many - perhaps most - believe. The day of reckoning will come and when it does many will be hurt and hurt badly. The ethical implications of this will not bode well for the Bernanke legacy.

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.

Additional disclosure: I am long TZA, TECS, FAZ and UVXY