Quantitative easing and the stock market rally

What is going on with the stock market? We have moved from a low of 672 on the SPX on March 9th to the current level of over 900 in less than 2 months. Could the economy be getting this good so fast? We know that equities usually turn at the bottom of the cycle and there has been some evidence that there is a slowdown of the slowdown but there has to be more going on to cause this change in expectations.

We suspect that the effectiveness of monetary policy is one of the drivers. The market bottom was reversed when Citicorp announced that they would have better than expected earnings; however, we know that this was associated with some smoke and mirrors. While the Citicorp announcement provided some relieve concerning banking problems, there was a further jump when the Fed decided to buy Treasuries and increase their QE program.

The problem is that the link between monetary policy and equity markets is not clear. There is evidence that the market reacts to declining interest rate or monetary easing. The decline could be with the easing policy or with an unanticipated change in rates. Unfortunately, we have less evidence of what will happen when monetary policy is eased but there is not a signal through a rates decline. Now we can look at real rates but here the signal becomes ambiguous especially if there deflation. The lines of causality between monetary policy and other effects are blurred so we cannot say what is driving the stock market.

The only other key QE case is Japan, but again the evidence is not clear. During the 1998-early 1999 period there was a significant Nikkei gain, but the QE period extended a number of year when the market was declining. There have been some studies of monetary environment but again this was measured through the direction of interest rates. Equity behavior during the Volcker monetary period is also mixed. Monetary tightening allowed the Fed to break the back of inflation but this was during a high inflation low growth period not a deflation like today. We cannot say what will happen when the Fed balance sheet explodes. The periods of very high monetary expansion for other countries was also during periods of high uncertainty which provides unclear signals.

Nevertheless, there is some evidence that a monetary policy that tries to smooth the economic cycle will reduce the equity risk premium which will cause a stock market rally. We believe that the stronger action from the Fed is leading to a belief that the economy will turn around sooner regardless of the economic numbers. Equities which have high leverage may see a benefit from higher inflation and P/E with equities is a real measure unlike nominal rates with debt. This has helped the equity rally. The question now is whether adding too much money will lead to higher nominal rates which will have a restrictive effect.

The evidence is not clear but if you are an equity investor do not fight easing.