Stock Markets: Monetary Policies Have Larger Impact Than Economic and Corporate Links

``This is the U.S. financial banking system and it will be defended. And if the U.S. cannot push through superconduits and rescue plans, foreign sponsorship will step up as it recently has. Whether they can pull the U.S. up or the U.S. pulls them down is another conversation altogether.”-Todd Harrison, founder CEO of Minyanville

Now going back to our original premise about “economy and corporate earnings” as drivers to the market, let us use the US equity markets as example.

Figure 1: Northern Trust: US Real GDP

Except for the recent perplexing third quarter surge in the face of a deepening housing recession and the worsening credit conditions, figure 1 from Northern Trust shows us that real seasonally adjusted GDP as measured by its percentage change since 2003 has been trending lower (superimposed blue arrow).

This means that while its economy has been growing in nominal terms, the speed of its variable changes relative to real economic growth had generally been slowing down post the dotcom bust.

Now if “economics-drives-stocks” then respectively, we should see some similarities in the price actions patterns of the S & P 500 as shown in Figure 3.

Figure 2: WSJ: Earnings Growth has been Slowing

But before we jump to the broad based index the S & P 500, a chart from an article in Wall Street Journal in Figure 2 likewise depicts of a slowdown in the year-to-year quarterly change in the earnings growth by the aggregate composite members of the major bellwether as indicated by the superimposed blue arrow over the left chart.

So again while earnings have been growing in nominal terms, the speed of its variable changes has notably been slackening since 2004.

Again if “earnings growth” equally drives stocks as commonly perceived by the public then respectively we should see some similarities in the price actions patterns in the S & P 500 as shown in Figure 3.

Figure 3: S & P 500: Quarterly Chart/Rate of Change

Figure 3 reveals of the quarterly chart of the major benchmark S & P 500 (black candle).

To compare with the performance relative to the economy in 2003, the major equity bellwether bottomed out then began its major turnaround to the upside.

In 2004 relative to earnings growth, the S&P continued with its vigorous ascent. This progressive advance has been strongly supported by the rate of change, manifested by the uptrend of the red line.

Thus, relative to price actions, the widely espoused view that “economic growth” or “earnings growth” drives the stock markets do not convincingly explain the performance of the S & P 500.

Instead, it does seem like a paradox: strong markets were coincident to slowing economic growth or deceleration of earnings growth. This inverse correlation could be described as “decoupling”, in contrast to commonly held popular views.

Figure 3: Economagic: S & P 500 and Fed Fund Futures

This is why it is imperative for us to identify, understand and monitor the driver/s that has a commanding edge to the markets, simply because by associating with the wrong cause such analysis may result to inaccurate projections and costly actions. Or in medical analogy, misdiagnosis leads to wrong prescriptive cures.

Figure 4 courtesy of Economagic provides us a more compelling correlation…market action fueled by monetary policies!

The chronology of correlation: Since the 2000 peak, the S & P (blue line) has been on a downdraft reflecting the dotcom bust. This was followed by declining Fed fund futures (red line). The S&P bottomed out in late 2002, whereas Fed fund futures bottomed in mid 2003.

Subsequently, Fed Fund futures climbed following S & P’s recovery as Fed rates hit a 60 year low. However Fed rates peaked in 2006, while the S & P continued its ascent which presently drifts at the upper ranges.

The correlation looks seductively linear, DECLINING FED RATES EQUAL TO DECLINING S & P 500 or vice versa, but appearances do not reveal everything or the caveat here is that like the folly of many analysis “correlation does not imply causation”.

Instead one should keenly observe that the S & P leads the Fed Fund Rates at critical junctures in a majority of circumstances. This has been the case except in 2006 where Fed rates paused while S & P continued to trek higher.

The clear implication is that the market’s direction is followed by corresponding Fed actions or that the US Federal Reserve responds to the actions in the marketplace!

When the market is in trouble, the Fed reacts by corresponding action…interest rate cuts and other forms of inflationary policies, thereby flooding liquidity into the financial system. Conversely, when the market recovers, US monetary officials technically siphon liquidity off by raising interest rates.

So the recent rate cuts translate to extant pressures or reflect bouts of turmoil in the marketplace.

As expected, the latent intoned subsidies by the Fed had been recently borne by the statements of Federal Reserve Vice Chairman Donald Kohn-policy must be nimble, flexible and pragmatic (Reuters)-and by Chairman Bernanke- ``renewed turbulence'' in markets may have shifted risks between growth and inflation” (Bloomberg) and the “Hope Now Alliance” (Bloomberg) or a pact with financial institutions to freeze interest rates.

These bailout expectations appears to have helped fueled the recent astonishing gains by the equity markets which we think could be more of a technical bounce.

Bottom line: In the decoupling debate, in appreciation of how US markets, the world’s largest and most sophisticated markets, have been influenced by its domestic policies, and thus, under the same prism we dare not dismiss the potential impact on the global financial markets by the corresponding actions that could be taken by major central banks.

Not even under today’s deepening trend of “financial globalization” which tends to increase linkages and therefore heighten correlations, will probably be enough to prevent markets from “decoupling” -in the sense that markets may perform independently or attain very low levels of correlation or dependency variables over the longer horizon. The distinct conditions of the underlying structure of the financial markets as well as the variance in the domestic currency regimes are likely to be the conduction channels for such marketplace divergence.