On September 13, 2012, the Federal Reserve issued a statement (found here) that an additional round of quantitative easing (QE3) was going to be the preferred method for monetary policy going forward. The QE3 would be in the form of $40 billion of monthly purchases of agency backed mortgage securities. The rationale for this policy implementation was explained to be put in place to ensure maximum employment and price stability. We wonder whether a natural state of maximum employment has already been achieved. After all, isn’t it always at the maximum level?
It is necessary to put the implementation of QE3 into perspective. The first official pronouncement of QE took place on November 24, 2008. At that time, the stock market, as reflected by the Dow Jones Industrial Average, had already declined –37.66% from the October 2007 high. The deployment of QE1 at the time resulted in a temporary bounce and then the stock market proceeded to complete the decline to the March 2009 low, an additional decline of –26%. A -26% decline as if there was no effort on the part of the Federal Reserve to stabilize the situation, speaks volumes of the relative ineffectiveness of such a policy.
The second iteration of QE took place in early November 2010. At the time, the Dow Jones Industrial Average was already in an established rising trend (+75% above the March 2009 low) and tacked on an additional +11.94%, to the April 2011 peak. After the April 2011 peak, the Dow Jones Industrial Average declined –15.91%. The implementation of QE2 in 2010 was nearly 5% above the October 3, 2011 low. Does billions of dollars of money thrown at the economy suggest that it was worth the stagnant or mild gains in the economy?
As we’ve said in our January 2011 article titled “Federal Reserve Isn’t to Blame for the Current Market Run,” and as demonstrated by the relatively mild gains and/or declining returns as represented by the Dow Jones Industrial Average, whenever monetary policy has been put in place, quantitative easing has little impact on the expected outcome for where the stock market and economy will go. Additionally, we've shown how in periods when the Federal Reserve didn't exist (1864-1913), the stock market would routinely rebound 50% to 100% of prior losses.
Why do we make comparisons between the stock market and Federal Reserve policy when actions taken by the Fed are intended to affect economic activity and not the stock market? The answer lies in a 2004 paper, co-authored by Ben Bernanke before he became Fed chairman, titled “Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment” which is THE basis for quantitative easing in the United States. On page 8 of the 113 page document, step one for effective QE (out of three) is stated as follows:
“..using communications policies to shape public expectations about the future course of interest rates…[1]”
This is significant because the stock market is the court of public opinion on all matters relating to current and future economic expectations. Dow Theory, a 110-year old approach to interpreting the stock market, has the following to say on this matter:
“The Averages Discount Everything — The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movements.[2]”
All initial communications by the Federal Reserve are meant to sway the public and is voted on by the stock market either rising or falling in acceptance or rejection of the Federal Reserve’s communiqué. The book by Benjamin Graham titled Security Analysis highlights the point that the market is an arena where votes are cast in the following quote:
“The stock market is a voting machine…[3]”
We believe that the Federal Reserve decides exactly how much they have to follow through with their “communication policies” based on the magnitude of the reaction from the financial markets.
For us to believe that quantitative easing is an effective tool in the court of public opinion and ultimately for the economy, we'd like to see both the Dow Jones Industrial Average and Dow Jones Transportation Average to exceed previous all-time highs on the news. Unfortunately, the latest announcement has not catapulted both indexes to new highs which, according to Dow Theory, puts the latest policy initiative in question.
Although there is little to demonstrate that monetary tools being put in place, like quantitative easing, are actually effective, what we are seeing is an emerging trend in when the Federal Reserve decides to take action. In the chart below we see that when the percentage change from a year ago of real gross domestic product (GDP) has peaked, the Federal Reserve will attempt to take steps to stop the declining trend of GDP.
Keep in mind that since QE2, real GDP growth has still managed to trend lower than the period before, on a percentage basis. This is not the ideal outcome of massive amounts of “liquidity” being “created.” As can be seen in the chart above, the overall trend in year-over-year (y-o-y) percentage growth in real GDP has reflected a pronounced declining trend in alignment with the peaks of 2000 and 2004. However, in the entire history of collected y-o-y percentage growth in real GDP, since 1947, the declining trend has been well established and should not be considered a new phenomena.
The fact that QE2 could not demonstrate y-o-y growth greater than the 2010 peak before QE3 was implemented suggests that the stock market and economy are easily susceptible to a major “shock” in spite of the Federal Reserve’s best efforts. An additional takeaway from our interpretation is that, unless under “emergency conditions,” the Federal Reserve Bank will implement massive amounts of renewed quantitative easing if real GDP appears to have peaked as was the case shortly before the QE3 announcement on September 13, 2012.
[1] Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack. “Monetary Policy Alternatives at the Zero Bound:
An Empirical Assessment.” Federal Reserve Bank, Washington D.C. 2004. PDF found here.
[2] Rhea, Robert. The Dow Theory. 1932. Barron’s Publishing, page 19.
[3] Graham, Benjamin. Security Analysis. 1934. page 452. found here.
