Considering the strong start to the year for equities, Ben Bernanke’s smile must be getting as big as the Federal Reserve’s balance sheet. The Fed Chairman is on record defending the wealth effect, which involves forcing investors into equities by punishing them through record low interest rates and quantitative easing. After an early lackluster reception from the latest QE announcements, Mr. Market is feeling quite optimistic these days.
In September, the Federal Reserve announced QE3, which buys agency mortgage-backed securities at a pace of $40 billion per month. The program is open-ended and will continue for as long as the central bank thinks is necessary. Stocks enjoyed a modest bump from the news, but the gains were fully retraced by Halloween.
However, Bernanke quickly put on his Santa suit and delivered an early Christmas to Wall Street. Three months after announcing QE-to-infinity-and-beyond, the Federal Reserve unveiled QE4, which purchases $45 billion of long-term Treasury securities each month.
Stocks gain across the board.
The initial reaction from QE4 was also tepid, but stocks reigned in the new year and money printing with gains across the board. In fact, it was the best January for the Dow since 1994 and the best for the S&P 500 since 1997. Both indices posted their best single-month performance since October 2011. According to TrimTabs Investment Research, nearly $80 billion flowed into stock mutual funds and exchange traded funds in January, the best monthly haul in at least a decade.
The momentum in stocks carried over into February as the Dow Jones Industrial Average recaptured the 14,000 level for the first time since October 2007. While reaching the old milestone is generating a debate about a great rotation from cash to equities, it is important to remember that the rally should be credited to central banks rather than improving fundamentals.
Mohamed El-Erian, chief executive officer and co-chief investment officer of Pimco, explains in a Fortune article, “Unfortunately, politicians both here and in many countries around the world seem more comfortable in – time and time again – kicking the can down the road rather than deal properly with economic challenges. Indeed, if it weren’t for the unusual activism of central banks, the Dow would be well below 14,000 today – well below. Also, the housing recovery would be less advanced and companies’ balance sheets banks less healthy; and many of the banks fortunate enough to be still operating would be struggling to restore large capital cushions and decisively overcome bad legacy assets on their balance sheets.”
Main Street is not feeling the wealth effect.
El-Erian also adds, “Temper your optimism with caution: There is a limit to how far central banks, acting on their own, can divorce market pricing from fundamentals.” In the meantime, Main Street does not need a reminder of the fundamentals.
The Dow at 14,000 today is a much different picture than in 2007. The headline unemployment rate in October 2007 was 4.7 percent, compared to 7.9 percent today. The latest data from the United States Department of Agriculture shows that nearly 48 million Americans are now on food stamps, compared to roughly 27 million in 2007. Additionally, the Commerce Department’s first reading on Q4 2012 gross domestic product dropped at a 0.1 percent annual rate, the first contraction in three and a half years.
Over the past four years, the major central banks around the world have provided more than $6 trillion in quantitative easing. When converted to U.S. dollars, the four major central banks have expanded their balance sheets to beyond $13 trillion, according to Hayman Capital. In comparison, this amount was $3 trillion a decade ago. While the Dow is near break-even since 2007, gold prices have more than doubled and gas prices on February 1 reached an all-time high for the date.
Bernanke appears to be accomplishing a wealth effect in many areas of the market, but Main Street is not smiling.
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