(Picture: Government officials test jumping off of the yellow line. Elazar charts shows how high that Fed spending yellow line is and then zooms in on recent data. Don't forget the ripcord.)
We wanted to follow up with what we see the Fed doing of late despite all the talk. Fed balances have been a key driver to stock market performance. We've decided to track some of these key metrics after bringing them to light in Is The Fed Buying Stocks and In Fed We Trust, Fed-Led '08 Meltdown Exposed, It's Setting Up Again.
In those two pieces we showed the apparent correlation between the Federal Reserve balances and the stock market level. As the Fed bought securities they added liquidity to banks, the market and the economy. It appears to have a direct correlation to stock market levels.
Here's the historic relation between changes in Federal Reserve balances ("YoY Change") and the S&P performance. (NYSEARCA:SPY).
As you scroll through the above grid you see that the change in Federal Reserve balances matched the S&P 500 moves pretty closely.
As a review, here is the yellow line we've been talking about (photo above) and its longer term chart relationship. As the Fed added liquidity to the economy (yellow) the stock market (green) lagged but went up as well.
The issue with this chart is best expressed by the picture itself. As we pointed out in "Fed Mulls Letting Stock Market Float" based on Fed speak we think the Fed knows its power over the markets. We also said in "Fed Mulls" that the Fed plans to "normalize" excess at some point. This chart, we think is the epitome of excess.
Regardless of what they do with rates, we care what they do with their transactions. Up or down it appears to be incredibly important directly to the market.
Ben Bernanke wrote that monetary policy has the most impact on financial markets. Here's what he said,
"The ultimate objectives of monetary policy are expressed in terms of macroeconomic variables such as output, employment, and inflation. However, the influence of monetary policy instruments on these variables is at best indirect. The most direct and immediate effects of monetary policy actions, such as changes in the federal funds rate, are on the financial markets."
You think they don't know where they took us and where we could be headed if they tighten? That could be why the inflation pick-up is getting overlooked. The Fed is stuck.
Pushing On A String
We've reported countless times that GDP and jobs are slowing despite the mounds of liquidity. Any tick down in liquidity will be a serious problem to the market.
And The Fed Is Still Talking Rate Hike, even with jobs slowing
Even with weaker jobs, the Fed is still talking about raising rates. They don't mention inflation but that's the only reason.
Now We Understand Why The Market Hit A Ceiling, Fed Spending Ceiling
Let's Zoom In On The Chart
The market this year reached where it reached January 2015. That was about the same time the Fed stopped increasing liquidity to the market. We think the market is stuck because the Fed is hesitant to add more liquidity. They are already off the charts. Because they have stalled, the market stalled.
That hurts the thesis of new ATHs (That's the simple theory that the market is going higher because it's at all time highs.).
Here's the last year and a half of Federal Reserve balances versus the SPY (This is the Fed's yellow line zoomed in).
If our yellow line's performance of Fed activity is any indication, it's no wonder why the market is stuck at all time highs.
Similar to our data through 2004, the market closely tracks the Fed spending liquidity levels. All of our pushing and swinging around in stocks for our many reasons is like us kicking the toes of a giant. Their moves matter much more than ours.
That said, there have been incredible drops recently in SPY as the yellow line stopped going up.
This tells us that the amount of liquidity in the market needs to rise to get the market to rise. Staying stagnant only causes volatility from here with a cap higher.
Like we saw with a small 25 bp hike in December, any tightening from this vertigo level is a giant risk to the markets.
And as we pointed out in "Fed Mulls Stock Market Float" that 25bp hike was on a 25bp base making it a historic 100% rate hike. It may sound silly but it had incredible implications.
Waiting For ATHs? Wait For Elazar's Yellow Line First?
If you are waiting for ATHs (All time highs) we'd simply wait for Elazar's yellow line to go higher. We think that could be a hint for new ATH. For now, we think the hint is volatility lower since that very yellow line IS NOT rising.
Here are the numbers for this year:
Last week's Fed move was for loosening but the year-to-date is still flat which, we feel, limits market upside and can cause volatility on the downside.
Brexit: Risk Reward is Poor
If our take is right then the trade into Brexit has more downside than upside. The risk/reward is not favorable for upside.
Elazar's Fed spending ceiling chart shows the market bumped its head many times around 210 and then fell by a wide gap.
Since we feel the Fed admitted they reached unnecessary spending levels (See here for proof) we don't see this yellow line going up. Therefore we see a cap in the market. Downside events, however, can happen.
The Fed's spending spree has hit a ceiling. The market followed the yellow line but lagged incredibly. The Fed has called its spending excess so we don't expect it to hit new highs. If they ever decide to jump off that yellow line the market will be, most likely, going down.
Nearer term, risk events like Brexit have a poor risk/reward. We see that the market has had trouble going higher. We think the main reason is that the Fed spending went sideways. That's the ATH cap. That said, risk events can cause downside with limited upside.
That sets up for a negative risk reward.
(Picture below: More government officials taking practice jumps off the yellow line.)
Good luck and please be in touch. All of your comments teach US a ton.
Elazar Advisors, LLC specializes in earnings and predicts, analyzes and reacts to earnings and earnings events as well as developing current company and macro stories with a hedge fund perspective.
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Disclosure: I am/we are short ES, BUT THAT CAN CHANGE AT ANY TIME.
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.