Today’s new paradigm: ubiquitous faith in the force of Fed easing

Over the past few months, I have mentioned several times that the present stock market paradigm is a ubiquitous faith that Central Banks and their endless QE will not allow stocks to go down. This is our modern day version of the “permanently high plateau” declared by the bulls at the market peak in October 1929. As I posted in this article and chart last week, every market top ends in the confidence of a “new paradigm” and this most recent belief is likely to be just as flawed and inaccurate as was faith in the endless China miracle in 2007 or the endless technology boom in 2000 and every other cyclical top in market history. This week, John Hussman takes today’s two most ludicrous paradigms to the wood shed. One: the myth that QE is all powerful and two: the myth that stocks today are cheaply valued:

Myth 1: As long as quantitative easing is underway, stocks will advance indefinitely.

This first myth is embodied in statements like “since 2009, there has been an 85% correlation between the monetary base and the S&P 500” – not recognizing that the correlation of any two data series will be nearly perfect if they are both rising diagonally. As I noted last week, since 2009 there has also been 94% correlation between the price of beer in Iceland and the S&P 500. Alas, the correlation between the monetary base and the S&P 500 has been only 9% since 2000, and ditto for the price of beer in Iceland (though beer prices and the monetary base have been correlated 99% since then). Correlation is only an interesting statistic if two series show an overlap in their cyclical ups and downs.

If you want to talk about causation, the case for X causing Y is more compelling if the fluctuations in X precede fluctuations in Y. Even in that case, we say that X “causes” Y only if observing X gives us additional information beyond previous movements in Y itself. In the case of quantitative easing, much of what we observe as “causality” actually runs the wrong way. Market declines cause QE in the first place, and the result is a partial recovery of those declines.

As I noted a few weeks ago (see Capitulation Everywhere), the effect of monetary easing has undeniably been very powerful in recent years. However, if you examine the data closely, this powerful effect is almost entirely isolated to a three-step pattern: 1) stocks decline significantly over a 6-month period; 2) monetary easing is initiated, and; 3) stocks recover the loss that they experienced over the preceding 6-month period.

Regardless of whether one looks historically or even since 2009, a careful examination of the data is very clear: the essential feature of QE has been the recovery of preceding market losses that the market experienced in the months preceding the initiation of QE, with the impact of QE on investor risk preferences invariably wearing off after about 40 weeks. We would not rely on that precise horizon, but it’s worth noting that the relevant market low in the most recent instance was on June 1, 2012…”

See the whole article here: Two myths and a legend

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