A survey released yesterday on the subject of the markets’ expectation for the future size Federal Reserve balance sheet has me curious regarding what another round of quantitative easing (QE) would mean for the equity markets. 70% of survey respondents believe the Federal Reserve will resume QE with the average expected increase in balance sheet size being $500 billion.
Several people have already weighed in with their opinion on what QE2 would mean for the markets. David Tepper, president & founder of Appaloosa Management, says there are only two scenarios (h/t pragcap.com):
1) The economy improves and stocks rise. OR
2) The economy will decline and the Fed will induce a rally in stocks via QE.
According to David Rosenberg, chief economist at Gluskin Sheff, Tepper is forgetting a third scenario in where,
“the economy weakens to such an extent that the Fed does indeed re-engage in QE, but that it does not work. So the “E” goes down and the P/E multiple does not expand.”
The two main reasons that QE is assumed to benefit the equity markets are by lowering interest rates and by giving asset allocators money to invest. The Pragmatic Capitalist has argued that QE will not be affective this time around; that lower rates and “cash on the sidelines” will not help.
While I agree that QE will not solve any of the long-term, structural problems we are facing, to be brief t it provides little help to the ‘real’ economy, I am not so quick to dismiss the short-term effect it may have on the equity markets. For those who tend to be a bit more bearish right now (myself included) due to weakening economic data and relatively high valuations, it is especially important to consider the implications of QE2.
First, there is the fundamental impact of lower rates to consider. Lower interest rates mean lower discount rates in free cash flow and dividend discount models. Using the current Shiller P/E10 of 21 (P = 1,147.10 and E = 54.7) and the formula for justified P/E, holding all variable constant save for r, [(1 – b) x (1 + g)]/(r – g)], we find that a .5% drop in the discount rate would result in an expansion of the multiple to 26, a 25% increase. If you are less optimistic about the effect of QE2 on lowering rates, even a .25% decrease in rates would imply a multiple of 23, or an 11% increase.
Second, is the issue of ‘Cash on Sidelines’. John Hussman has thoroughly debunked the myth of ‘cash on the sidelines’ during normal financial market operations but I believe quantitative easing is another matter.
A simplified example goes like this; you have three parties, one with $100 in cash, one with $100 in equities and one with $100 of bonds. For the party with cash to buy either equities or bonds they would have to trade cash for equity and the party selling equities would now have cash. There is no cash on the sidelines since one party must hold the cash at all times. However, under QE there is a fourth party, the Federal Reserve. The Fed essentially replaces the $100 of bonds with cash. While there are now, no additional financial assets in the system (equities or bonds) there is additional cash. The entity with cash can hold the cash and earn interest (not likely with short-term rates near zero), lend the money out (bank are not doing this due to deleveraging in the private sector), or invest in financial assets. Basic economics tells us that with no increase in supply (in this case financial assets) and an increase in demand there should be an increase in prices.
At this point I think it would be beneficial to look at the impact of QE1 on the equity markets. (Click on any chart for a larger view)
As you can see in the chart above the QE1 began in the October 2008 time period with the expansion of central bank liquidity swaps, term auction credit and commercial paper funding. Not until the March 2009 period did the Fed begin to shrink the size of these programs but kept the total balance sheet size more or less static by increasing treasury, agency and MBS purchases.
As you can see in this chart the timing of increased purchases of treasury, agency and MBS securities lines up very close to start of the rally in the S&P 500.
In fact, the correlation between the per cent increase in these assets and the increase in the S&P 500 was .93 over the period.
Taking the linear regression over the same period lends an intercept of .163 and an x variable of .195. If we plug in the $500 billion expected (24.3% increase, $500B / $2.054T)balance sheet expansion into the formula we get an expected increase in the S&P 500 index of 21%.
In conclusion, I am not saying that QE2 will have the same effect on the equity markets as QE1. There are differences between the current scenario and March 2009; namely the lack of new fiscal stimulus and higher valuations in the markets. Furthermore, due to the zero bound of interest rates, there is a diminishing return to additional QE. Additionally, further periods of QE would have been helpful to analyze; unfortunately the Federal Reserve data only goes back to 2002.
These caveats aside, for those with a bearish outlook, I believe it would be prudent to consider the possible short-term, simulative effects of QE2 on the financial markets.