Fed’s effect on the Stock Market

Saw this post earlier today by u/laminin1, and started a reply that got a little lengthy, so I went ahead and made it a separate post.

So first of all, I am far from an expert on this, but I have been doing a lot of research on the FED and the money supply. As part of a bigger project that I'm working on (that I might present on here some day) I have accumulated some good information on this specific topic. I will present some of this and then share my 2 cents based on what I've learned so far.

As I started out, one of the first things I wanted to know was how the FEDs balance sheet stacked up in comparison to the major dollar denominated areas of the economy. Here's what I found:

Cryptos: $.16T

M0 Money (physical cash): $1.84T

FED Balance Sheet: $6T (up from about $4T before CV)

Gold: $7T

Dollar Denominated Debt (outside of US): $11T

US 2019 GDP: $21T

US Housing Market: $30T

M1 Money (M0+savings/checking deposits): $37T

US Private and Public Debt: $52T

Stock Market: $74T

M2 Money Supply (M0+M1+other liquid assets): $90T

Derivatives: $1,200T

Along the way, I learned quite a bit, and have (3) points I'd like to share. Again, these are just my opinions, so hopefully some smarter folks can correct or add to what I've laid out. I'm much more interested in discussing/learning than persuading or being right, so please feel free to pick my points apart.

1. FED bucks – While $2T of extra dollars in the economy is an astounding number and is certainly unprecedented, I don't think it (directly) affects the stock market as much as I thought before I started reading up about this. For one, while it's impossible to know exactly how much, I think the percentage of FED generated dollars that trickled into the market is rather small (though admittedly, this gets extremely complicated and tough to cover why in a single post). Secondly, even if every single dollar somehow made it into the market, $2T is still only a smaller percentage of the total market cap and would not come close to making up all of the massive retracement we've seen since the March lows. I think that ultimately the optimism the fed purchases create are much more of a factor on the stock market than the actual dollars themselves.

2. Deflation – If the economy remains in recession for an extended period of time, there is much more outstanding US dollar denominated debt at risk of defaulting than the FED would ever be able to responsibly inject (at least when they still followed the rules of the federal reserve act). The other problem is, even if they do set the printers into overdrive to perfectly match the rate of deflation, the ability to get the right amount of dollars in the right places, is a nearly impossible task. As we've seen with the stimulus packages so far, the government is extremely inept at effectively allocating resources correctly. To fully stop the massive wave of defaults we have coming, we would need a cooperative government, along with the fed, fairly distributing trillions and trillions of dollars with such precision that we got it correct, right down the individual debtor. We have protections in place that restrain the gov and FED from manipulating our economy too much in this manner. This is a good thing, but there really aren't existing processes that would allow for the selective distribution on a massive (yet precise) scale this would require. I could probably do an entire separate post on the money cycle and how money gets into and flows through the economy, but just suffice it to say it is an extremely convoluted, corrupt, and inefficient process. Another problem is, as shown above, nearly $11T of that debt is outside of the US. These economies are mostly all in worse shape than the US and it will be very challenging for them to get their hands on the dollars they need to service their debts as their economies shrink (lookup Milkshake Theory if you are interested in more information on this). The potential for all this massive deleveraging (reduced dollar supply as debors default) and an increase in demand for dollars should drive the dollar up vs other assets (deflation). I think the reason we haven't seen it so far is this will take months and even years to fully play out. Even though savings levels across the board are extremely low (personal, corp, gov, etc), these institutions aren't going to default after just a month or two of a receding economy.

3. Nowhere else to go with money – So why does the stock market keep going up then? The best conclusion I've been able to reach is, compared to other options the stock market is just as good (or just as bad) as anything else and people still have money on hand that they need to do something with. Yeah, the stock market is in a bubble, but so are many other investment options. I think the big institutions know that deflation is ultimately on the horizon, but as mentioned above, it will take a long time for the deleveraging to play out and while everyone is still flush with cash, there are gains to be made on the bullish short-sightedness. They will be converting to cash as they sell out at these high retracement levels, but again this isn't going to necessarily happen overnight. I think the average retail investor (myself included) expects these moves downward to come more quickly because of how fast and extreme the first move down was. However, if you look back in history, past bear markets played out much slower and longer than that. While the market could tank again next week, it could be also be several months or more.

So based on this, my strategy for the rest of the year is to hold mostly cash, a little gold and silver (as a safety measure), and I do have some active shorts on (in hinds sight I probably would have gotten into these after some more decidedly downward action, but am fine holding in the meantime). I don't know if this will all play out, but I do not feel comfortable buying in at these prices and am completely fine missing out (on what I believe) to be short term gains of the bull market hysteria I've been seeing.

Anyway, sorry for the long post, but hopefully someone gets something out of it. Looking forward to reading the replies.