Stock market bears think bulls’ buying is misplaced and based mostly on momentum. Bulls counter that they have a thesis: Stocks will rise no matter what happens to the economy and with the deadly virus.
But now the first crack has appeared in bulls’ argument. Let’s explore this with the help of a chart.
Please click here for an annotated chart of the Dow Jones Industrial Average ETF
which tracks the Dow Jones Industrial Average
Note the following:
• The chart shows the expansion of the Federal Reserve’s balance sheet. As the chart shows, the Fed’s balance sheet stood at $0.87 trillion before the financial crisis in 2008. In March 2009, when stocks rebounded and Arora gave a buy signal, the Fed’s balance sheet stood at $2.08 trillion. In 2018, the Fed’s balance sheet totaled $4.4 trillion.
• The chart shows that when the Fed reduced its balance sheet to $3.77 trillion, the stock market eventually fell about 20% in December 2018.
• The chart shows that the stock market drop scared the Fed, which did an about-face. The Fed started increasing its balance sheet. The stock market took off.
• The chart shows that in October 2019, the Fed started adding liquidity, and the stock market took off to a new high.
• The chart shows that the Fed’s balance sheet stands above $7 trillion today and is on its way to $10 trillion.
• Previously the stock market was levitating because investors were hiding in the five big tech stocks of Apple
Now as the Fed’s actions seep into the economy, the stock market rally has considerably broadened.
• The sum total of the foregoing is that huge gains in the stock market over the past decade and the stock market rally since the coronavirus low in March is primarily driven by the Fed.
Here are the four elements of bulls’ thesis:
• If the economy becomes strong, stocks will rise.
• If there is a vaccine or antiviral, stocks will rise.
• If the virus mounts a resurgence and there is no vaccine and no antiviral, stocks will rise because of more money printing by the Fed.
• If the economy becomes weaker, the stock market will rise because of more money printing by the Fed.
Until recently, the Fed has been unreasonably intransigent in that it will continue money printing even if the economy became strong and there was no need for it.
The stock market has been eating up the Fed’s intransigence. When the Fed announced it will buy individual bonds, the stock market loved it.
A crack appears
Fed Chairman Jerome Powell is a smart man. The way he came across in his press conference after the FOMC policy decision last week was troubling in that he was going to do whatever it took without regard to consequences and limits. Why would a smart man like Powell show such intransigence?
Pat Toomey, a U.S. senator from Pennsylvania, was able to get the truth out of Powell. Now it is clear that Powell is being clever in exhibiting intransigence because he wants everybody to believe that the Fed is all in and there are no limits to what the Fed can do.
Based on the exchange with Toomey, it is clear that Powell knows his limits and, in reality, what the Fed can do has limits. The Fed may have difficulty going far beyond the present programs. Here are the key excerpts from what Powell said:
• “We’re not actually increasing the dollar volume of things we’re buying. We’re just shifting away from ETFs toward this other form of index.”
• “If market function continues to improve, then we’re happy to slow or even stop the purchases.”
• “And I don’t see us as wanting to run through the bond market like an elephant doing things and snuffing out price signals and things like that.”
The crack in the bulls’ thesis is that contrary to their belief, the Fed is becoming measured and may have difficulty expanding its balance sheet beyond $10 trillion. In plain English, unlimited money printing is highly unlikely.
Disclosure: Arora Report portfolios have positions in Apple, Amazon, Alphabet, Microsoft and Facebook. Nigam Arora is the founder of The Arora Report, which publishes four newsletters. He can be reached at Nigam@TheAroraReport.com.