A signal from the stock market

June 14, 2010 – The stock market is often acclaimed for its forecasting ability.  Stock prices peak long before the downturn in economic activity that generally results in a recession and a prolonged decline in the stock market.  Then after this lull in the economy, the bear market low in stock prices leads by several months the upturn in economic activity. 

As a consequence, since making a low in March 2009 following the turmoil surrounding the Lehman Brothers collapse, many economists have been proclaiming that the rise in the S&P 500 Index, the Dow Jones Industrial Average and other stock indices is forecasting better economic conditions.  So far, it hasn’t worked out that way. 

The economy is fragile, with job creation being weak and unemployment therefore remaining menacingly high.  Federal government revenue – which is perhaps one of the more reliable indicators of strength in the economy – is not improving after a long downtrend. 

A number of economists have indicated that the economy has improved because of the federal stimulus money as well as other huge increases in spending by the federal government.  If so, why is unemployment stubbornly high, and why aren’t federal tax receipts climbing? 

In any case, the stock market has been weak of late, so it therefore seems reasonable to question whether the stock market’s rise from March 2009 is really forecasting better economic activity.  Could it possibly be that something else caused the stock market to climb from that March 2009 low and therefore send a false signal about the potential for economic activity?  The following chart says that there is indeed another factor at work.

There is a clear relationship between the rise in the S&P 500 Index from its March 2009 low and the Federal Reserve’s purchase of US government debt instruments, which it calls “quantitative easing” (QE).  Another term for it is money ‘printing’.  The Fed is simply turning US government debt into more dollar currency, which of course debases the dollar.  It also explains the correlation in the above chart. 

Note how the S&P Index started climbing with the commencement of QE.  The S&P dropped early this year when the Fed announced QE would end.  Interestingly, the stock market soon rallied thereafter, probably because few believed that the Fed would really take away the ‘punchbowl’.  But it did, and the S&P has been in a downtrend ever since.

When more dollars are being created than demanded by economic activity, this surfeit of dollars must go somewhere.  This observation is particularly true when real (i.e., inflation-adjusted) interest rates are so low that bank deposits become unattractive, as is presently the case.  The above chart illustrates that one of the places where these newly created dollars ended up was the stock market. 

Now that the Fed has stopped printing, the S&P 500 Index not only stopped rising, but began falling to reflect the true state of underlying economic conditions.  Consequently, I expect that there will be new calls in Congress for another stimulus package, but more immediately, it seems likely that the Federal Reserve will recommence its purchases of US government paper.  Quantitative easing, I expect, is about to get a second chance at reviving the moribund US economy.

It didn’t work the first time it was tried, and won’t work this time either.  Policymakers continue to ignore the fundamental problem plaguing the US economy.  There is simply too much debt.  The only outcome we can expect from more QE is a debased dollar. 

It is interesting to note that the dollar has been rising against the euro for several months.  While the Fed has for now stopped QE, the ECB is actively pursuing QE.  So the result is a ‘strong’ dollar relative to the euro. 

Whether the dollar continues to climb against the euro is largely irrelevant in view of the more important observation to make here.  In a world of floating currencies that bob up and down relative to each other depending on varying central bank policies, they are all sinking against gold.

Gold closed this past week at a new record high against the dollar.  It made a new record against the euro the week before.  Gold is rising against all of the world’s currencies, and its ascent will only be hastened if the Federal Reserve restarts QE.