Wednesday, April 20, 2011

Is the Stock Market Up Because of QE2?

There are a lot of reasons to be bearish against the stock market right now.  Unemployment is still near 10% (according to government statistics), banks are holding back when it comes to lending, and there is an overall anti-risk and anti-investment mentality right now in the business world, especially because of excessive government.

There is one reason for the stock market to go up.  That reason is the Federal Reserve creating new money out of thin air.  So to answer the question in the title of this post, yes, the stock market is up because of QE2, along with QE1 before it.

I have argued before that an increase in the overall stock market is due to monetary inflation.  While the stock market does not necessarily track the money supply in the short term or even the intermediate term, there is a strong correlation in the long term.  If the Fed kept a completely stable money supply where it did not increase it or decrease it at all over a long period of time, then the stock market would trade in a relatively narrow range.  If there is no new money to bid up prices, then the prices won't be bid up.

For those who understand Austrian economics, or for that matter Chicago school economics, you are aware that the overall price level changes because of changes in the money supply.  If there were no changes in the money supply, prices, in general, would not go up in a free market.  In fact, in a free market, prices would actually fall due to the increases in production and technology.  If you accept this fact for consumer prices, then it should not be much of a stretch to apply the same thinking to asset prices.  So while certain stocks may go up or down in price, the overall stock market would stay relatively flat if there were no changes in the money supply over a long period of time.

This is why you should not use the stock market as a predictor of the overall economy.  The stock market has been going up big time for the last couple of years.  But this is following the initial bailouts and a doubling of the monetary base.  Now we have QE2 (more money creation) that is supposed to last 8 months (until June).

This is why I have been hesitant to recommend large short positions.  I certainly think there could be some severe pullbacks in the stock market and a small short position might turn out to be a good speculation right now if you get in and out rather quickly.  But overall, it is hard to fight the Fed on this one.  The monetary base continues to go up and this new money is going to go somewhere.  Things like gold, oil, silver, and food are going up, but you can add the stock market to that too.

This is why we should not judge the Japanese economy too harshly based on its stock market.  It has been down or flat for the last two decades, but you can partially chalk that up to the fact that its growth in the money supply has been much tamer than elsewhere.

There are no guarantees that the U.S. stock market will keep going up, but if the Fed keeps creating new money out of thin air, it is hard to bet against it.

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