Stocks and the Federal Reserve -- Necessary Pandemonium

Let me be clear from the outset: The Federal Reserve has not only been justified in its aggressive stance toward monetary policy over the past five years, it's also been effective.

Fears of inflation were wrong. Completely. Price appreciation isn't too high; the problem is that it's too low.

And the idea that the benefits of the central bank's policies -- namely, the three successive rounds of quantitative easing -- were outweighed by their detriments, exhibits abject ignorance about the source of our economic malaise. By driving down long-term interest rates, the Fed allowed tens of thousands of homeowners to refinance their mortgages, and thereby free up income for consumer spending. The latter, mind you, accounts for more than 70% of our gross domestic product.

You can see this in action by reading the quarterly reports of any of the nation's largest banks. In the first quarter of this year, for example, Wells Fargo underwrote $109 billion in mortgages, the vast majority of which were refinances. The same was true at Bank of America, though to a slightly smaller degree, given that it originated a total of only $24 billion in home loans over the same three-month period.

But that being said, people who argue that the Fed's policies don't have negative side effects are also deluding themselves. When you inject $2.5 trillion of liquidity into an economy, it's going to inflate asset prices, which is exactly what happened.

Between the beginning of last September, the same month the Fed announced QE3, and the middle of this past May, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the S&P 500 (SNPINDEX: ^GSPC  ) climbed by 18% and 19%, respectively. And if you want a more extreme example of this, just cast your eyes across the Pacific to Japan, where the benchmark Nikkei (NIKKEIINDICES: ^NI225  ) soared more than 80% since the government rolled out a similar, albeit more extreme version of the same thing.

Why are higher asset prices a bad thing? In and of themselves, they aren't. One could even make a convincing argument that they've been good. The accompanying wealth effect makes consumers feel more confident and, therefore, willing to, well, consume -- which, again, as I've already noted is the bedrock of our economy.

Where we run into issues, however, is on the downside, triggered by the inevitable pullback in monetary easing. And this is where the necessary pandemonium referenced in the title comes in.

As you can see in the table below, in June, the first full month after Fed Chairman Ben Bernanke intimated that the central bank could soon begin to taper its $85 billion in monthly bond purchases, things went haywire. The average daily movement of the Dow nearly doubled to 136 points, and the blue-chip index either advanced or declined by a triple-digit margin in 80% of the trading sessions.

Month

Percent of Days of Triple-Digit Moves on the Dow

Average Daily Move

January

5%

61

February

37%

77

March

10%

54

April

32%

74

May

36%

73

June

80%

136

Source: Yahoo! Finance

The big question now, of course, is what does this mean going forward?

To be clear, the Fed hasn't said that it will taper its bond purchases, only that it may soon begin to do so. Consequently, once it does finally make that decision, which could happen at any time now depending on how the economy performs, I think it's safe to assume that volatility could even pickup further. And it's for this reason that investors would do themselves a favor over the next few months by temporarily misplacing the password to their brokerage accounts, as buying and selling in this type of environment will almost invariably lead to substandard performance.

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  • Report this Comment On July 04, 2013, at 8:04 PM, Bidnow73 wrote:

    John - We recognize that your articles are written from the perspective of a stock market investor. However, your claim that fears of inflation are completely wrong seem to me to be completely wrong. Your linked prior articles have many wise and sage comments from others clearly more experienced than you. Perhaps you should re-read those comments. Better yet, if you are lucky enough, perhaps you should go and talk to your grandparent(s) about your opinion of inflation/taxation. The Fed's enlargement of the money supply is unprecedented in the history of the United States. Claiming that there is nothing to be concerned about seems the height of arrogance as well as contradictory to actual historic events of hyper-inflation and governmental entity demise.

  • Report this Comment On July 04, 2013, at 11:32 PM, PrintPrintPrint wrote:

    John, as soon as I read "fears of inflation were wrong", anything you wrote after that held zero truth in my mind. Let's see what inflation TRULY is, that being what the CPI tells us if the rules were the same as they were in 1980.

    From Q1 2011 to Q1 2013:

    Education: +39%

    Groceries: +6%

    Health Insurance: +111%!

    Utilities: +35%

    Babysitters/Daycare: +65%

    Tuition: +70%

    Current CPI excludes food and energy costs, which everyone needs in their everyday life.

    Rising income, property and sales taxes are not included in any of the BLS inflation numbers. Would you not include taxes as the cost of living?

    John, you need to understand that the CPI as it works currently doesn't reflect reality. Admitting true inflation numbers would increase COLA expenses for an already bankrupt nation. There is simply no way to stop QE without breaking promises to millions upon millions of people. At that point, society breaks down, and it's welcome to the Thunderdome.

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