This article reveals some special powers of the Fed Chair -- powers that no one knew about before!
A few weeks ago I generated a resesarch hypothesis -- not data mining the way most Wall Street research is done -- but actually starting with the hypothesis. We can now reveal the amazing results.
To understand the significance of this research, let me begin with a relationship that has gotten a lot of buzz over the last few months: The impact of QE II on the stock market. For the purposes of this comparison I will focus on the period from Labor Day 2010 (the time of Bernanke's Jackson Hole speech) until the end of the year. Here is the chart.
The horizontal scale is in Billions, of course. (The chart would look nicer except for the nagging illness of our resident chart expert, who clarifies and beautifies my ideas. Since I want to share this before Wednesday, you will have to live with the bare bones presentation).
The strong relationship is evident. I often warn against just eyeballing these things, since the eyes often deceive. The calculated correlation is .86, which means that the QE II purchases "explain" about 74% of the variation in stock prices. Well done!
Let us now turn to the new Fed power -- depicted in the chart of our "mystery variable."
This is obviously another great relationship, confirming my original hypothesis. The correlation is .92, so Bernanke's QE II power explains even more of the variation in the mystery variable -- 84%.
So what is the special power?
Ben Bernanke can turn off the sun in New York City!
What a guy! These are real super powers. The mystery variable is the hours of darkness in NYC.
At this point there will be some who are (correctly) objecting that correlation does not prove causation. They will (correctly) point out that there is no logical relationship between Fed Treasury purchases and night time hours in NYC. These are merely two events that happened to take place in the same time frame.
A good challenge would be to continue the series beyond the arbitrary points I chose to see if the relationship continues. I admit that it does not. I intentionally distorted the results by stopping the series at the time of the Winter Solstice. If you extend the series the relationship reverses dramatically. Fed purchases continue; daylight hours increase. Correlation does not prove causation.
I did this to illustrate how this cheating is commonplace in widely-publicized Wall Street research, the stuff you read about and see on TV every day.
But what about the Treasury/S&P 500 relationship?
For those of us who took the class in Money and Banking and remember any of it, the popular hypothesis makes no more sense than the causal reasoning about daylight hours. The proponents refer to vague statements about printing money, injections of liquidity, speculators getting more funds, and the like.
In fact, the Fed purchases do not directly provide any funds for speculation. The increase in the monetary base does provide the potential for more M2, but there has been only a modest effect on that front. There is no direct addition to funds for speculation.
To summarize, none of those who explain the market rally in terms of Fed action provide any reasoning for the relationship -- unlike the simple, logical explanation that the economy and corporate earnings got much better.
But we can test this. We can simply extend the Fed/S&P relationship to current times, the exact same test that a fair-minded person would have applied to my silly daylight idea.
It is obvious that the relationship has broken down. In fact, in the period since April 1st the correlation was -.54. That's right. The continuing injection of Fed liquidity over the last ten weeks has had a negative effect, refuting the hypotheis of direct causality.
The first conclusion we should reach is that there is a very low bar for research studies on Wall Street. At a minimum, we should be asking the highly-paid experts who were eager to embrace correlations and causation to update their work. This is a simple request. It is easy to do for anyone who has the data and the research model in place.
Few will take up this challenge, because it will expose their errors. Those who respond will come up with some lame-ass explanation about psychology. That would be correct, and it is important. It is all about psychology, and they should have recognized that in the first place.
The biggest effect of QE II was the sense that the Fed was on the job. Ben Bernanke made a mistake in claiming success of the program because of stock market effects. This should not be the basic test of Fed policy and he should have known better. The Fed always talks about market reaction as one of many factors, but it should not be a goal.
The most important takeaway from this article should be the following:
The Fed created a false understanding of QE II -- how it worked, and the expected effects.
Bernanke tried to explain in his last press conference why ending new purchases was not important as long as the Treasury holdings were maintained -- what he called "stock versus flow." It was too late. The explanation was too difficult and too technical.
Since the Fed will not change policy, so it comes down to whether he can explain it more convincingly than he did the last time.
I do not like the odds. Traders and the media all thirst for QE III. They think we are about to have another recession with cratering earnings. The Fed does not agree and will not satisfy their expectations.