Confidence Key

"You know, most people would kill to be treated like a god, just for a few moments."
--Norman Dale (Hoosiers)

The correlation between stock prices and quantitative easing (QE) is unmistakeable. Increasingly, the SPX has been in lockstep with Fed balance sheet expansion:

In the rare periods where the Fed has not been intervening in markets over the past 5 years, stock prices have floundered:

Because the Fed views the same charts that we do, we know that it will be reluctant to remove any degree of stimulus that materially hurts stock prices.

This situation raises a couple of interesting questions. What will ever cause the Fed to retract QE? And, if the Fed does not retract QE, then what will ever cause stock prices to go down?

Some believe that the answer to the first question is: nothing--at least nothing that will cause the Fed to retract QE voluntarily. Institutional hubris grows by the day at the Fed--each day that stock prices levitate and there is no hyperinflation from printing $trillions increases conviction that policymakers have stumbled upon an economic elixer of magnanimous strength. To those who own stocks, the Fed is god-like. The Fed has bestowed unto them huge amounts of paper wealth. Humans who think themselves godlike rarely relinquish their iconic pedastals willingly.

Of course, removal of QE may not be of the Fed's volition. Instead, bond markets may tank, or signs of Big Inflation may become evident to the masses. Perhaps awareness will grow that what the Fed is doing amounts to the greatest wealth transfer in the history of the world--and people wake up to the robbery in progress.

Short of such forced withdrawal, however, many investors sense a QE Forever situation--and a concommitant high stock prices forever situation. If the Fed has our backs with eternal QE, they ask, then how can such a situation ever take stock prices down?

The answer to this question first requires thought about the correlation reflected by the first graph above. On the surface, strong correlation between the Fed's balance sheet and stock prices suggests a high degree of causality--i.e., the more money the Fed prints by buying securities, the higher stock prices will go.

It is true that a necessary condition for stock prices to fly higher here is presence of massive Fed credit creation and securities buying. But it is not a sufficient condition. What is also required is confidence--confidence that the Fed knows what it is doing, and that the interventions will work.

Such confidence has been in place so far. But the real issue involves whether such confidence will persist going forward. What would cause confidence in the Fed and its actions to decline? How likely are such causes?

If you answer "Nothing" and "Near zero," then you have nothing to worry about.

However, if you sense that the mother of all bubbles is an expanding bubble in confidence--in confidence in the competence of monetary bureaucrats, then it is easy to see how at some point, the relationship between Fed balance sheet size and stock prices reflected by the first graph above begins to diverge and break down.

Stated differently, the correlation evident in the first graph can be seen as a spurious one. If confidence in the Fed breaks down, then the correlation goes away or perhaps even turns negative.

position in SPX