Stock Market Investors Don’t Fight the Fed

By: Hans_Wagner

Martin Zweig, in his investment book “Winning on Wall Street” points out investors should not “fight the Fed”. In his book, he discusses the relationship between the discount rate and the performance of the US stock market. As he showed, most of the time, a rise in the discount rate leads to a lower average share prices. A drop in the discount rate leads to higher average share prices. Another concept called “two tumbles and a jump” indicates that two decreases in the discount rate within a six-month period lead to a jump up in the stock market. On the other hand, one or two rate increases within a 6-month period are moderately bearish for stocks. Three or more rate increases are extremely bearish.

Martin’s point is you should not fight the Fed when they are intent on moving interest rates either up or down. Given that this is still true in today’s environment, what might take place over the next six to twelve months with interest rates, especially the discount rate?

Monetary Policy

Before I get into a way to assess when interest rates will begin to rise, it is important to understand monetary policy responsibility of the U.S. Federal Reserve. As stated on the Federal Reserve site the Federal Reserve is responsible for:

Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices and moderate long-term interest rates

The responsibility for the pursuit of maximum employment, stable prices, and moderate long-term interest rates can be on conflict, especially in times of economic trouble. Presently, the Fed is doing all it can to encourage economic growth and avoid deflation. Part of this effort comes through near zero interest rates and by adding a lot of money to the financial system. Once it does succeed in overcoming the deflation threat, the U.S. will be threatened by the potential for inflation, as all the money pumped in by the Fed looks for a return. To help offset rising inflation the Fed will raise rates and sell securities it holds to absorb some of the excess money. Higher rates will slow economic activity and slow job growth. There in lies the conflict.

Role of Money in the Economy

In a normal economy, the amount of monetary stimulus we are witnessing would quickly lead to higher inflation. In fact, many people are worried that the U.S. will face very high interest rates in the next several years as all the money that has been created will cause another asset bubble and an inflationary spiral. After all Milton Freidman taught us, that inflation is a matter of printing too much money. Depending on the measure you use, the Fed has been printing a lot of money.

The St. Louis Federal Reserve Bank through its FRED database has an extensive set of economic and monetary information. The chart below shows the adjusted monetary base, which is cash plus bank reserves held at the Fed. All banks must keep a certain amount of money with the Federal Reserve.

Money is not a simple item. Depending on where and how it is used or held, it is counted in a different way. The adjusted monetary base is one of the simplest form of money.

As you can see, the adjusted monetary base grew at a slow pace year after year until recently. Then in late 2008, the monetary base exploded up, more than doubling. This huge expansion in the monetary base is what makes so many analysts worried that the U.S. is facing high inflation. Just talk to a gold bug as they see this chart as a clear indication the price of gold will more than double to $2,000 and ounce due to higher inflation. However, there is more to the story.

One of the important factors to understand when looking at the money supply is what is knows as the velocity of money, which is the average frequency an amount of money is spent over a specific period of time. This can get complicated quickly.

Let’s take a small economy that existed on your street when you where a child. You set up a lemonade stand and sell a glass for $1. Your friend sets up a cookie stand and sells cookies for $1.00. Another friend down the street sells icicle pops for $1.00. Each of you starts with $5.00 in cash for a total of $15, equivalent to a monetary base of $15. Things are a little slow so you buy three cookies and two icicle pops from your friends spending all of your $5.00. Your friends are thirsty and buy $5.00 worth of lemonade from you. Then your two friends spend their remaining $5.00 on cookies and icicle pops from your other friends. In the end, everyone ends up with $5.00 while having enjoyed cookies, icicle pops, and lemonade. Since the money spent has only passed through each hand once, the velocity of money for that day is 1. The Gross Domestic Product for this little economy is $15.00.

On the next day, the same thing happens. Everyone spends their $5.00 and ends up with $5.00. Now the money has changed hands twice over two days. In this case, the velocity of money is 2 over the two day period. Yet the amount of money in place remains at $15.00. The GDP for this little economy is $30.00 over the two-day period. The monetary base remains at $15.00.

For the mathematicians out there you can make this into a simple formula of nominal GDP = Money * Velocity or Y = M*V.

On the third day, another friend opens a hotdog stand but he does not have any starting cash, so the monetary base remains the same at $15.00. You and your first two friends decide to spend their $5.00 among the other three friends buying and selling lemonade, cookies, icicle pops and hotdogs. Let’s say the three original stores earned $4.00 and new one earned $3.00. On average, each person ends up with $3.75. ($15/4=$3.75). At the end of the day, the three original friends figure that they are in a depression. Sales have plunged to $4.00 on average. The new member of the economy is excited as she now has $3.00.

So what happened? GDP for the day stayed the same; it just was spread among more members of the economy. The total aggregate of money did not change, remaining the same at $15.00. The velocity of money stayed the same. Three-quarters of the population had a severe recession, while one is happy with her newfound money. Overall business is not good.

The next day a neighbor decides to spend some money and buy something from each child’s store, spending $1.00 at each store. If the each friend still spends their money as before, their $4.00 from the first three stores and the $3.00 from the new store, the GDP of our street economy just rose to $19.00 for the day. $15 + $4.00 from a benevolent neighbor = $19.00. The aggregate money supply rose to $19 as well. However, the velocity of money remained the same at 1 for the day. The three original stores took in $5.00 and the new store took in $4.00. Things are looking better.

The neighbor injected money into the economy to help it recover, much as if the Fed injects money into the economy. In fact, it is just like the Fed growing the money supply to encourage growth in the economy. In addition, while the money supply grew the velocity of money stayed the same.

The next day the same neighbor once again spends $4.00 at each store. The kids spend their $5.00 or $4.00, their earnings from the day before. The original stores now have $6.00 each and the newer store has $5.00, bring the total economy to $23.00. The aggregate money supply is now at $23 as well. Things are better than ever. The benevolent neighbor once again stepped in to help everyone.

Being an enterprising individual, you realize that there is more money to be made if you raised your prices from $from $1.00 to $1.50 for a glass of lemonade. After all, there is more money around and you want more of it. The next day you sell four glasses of lemonade to each of your friends for $1.50 collecting $6.00. Your strategy worked. Your friends keep their prices the same. Unfortunately, one of your friend’s store only sell $4.00 worth of goods while the others sell $5.00. Since you sold $6.00, only $17 was available for the other three stores to share. ($4.00 * 3 = $12 + $ 5.00 = $17.00). Your price increase caused the other stores to suffer, since the total money supply did not increase. Neither did the velocity of money as it only passed through one had during the day.

The next day the other stores raise their prices to $1.50. Once again, the neighbor bought goods from each store, spending $1.50 instead of $1.00. Now the total money supply increased to $29.00. The GDP for our street economy rose to $29.00 as well. Everyone is making more money, but it cost more to buy goods. In fact, you cannot buy more with your newfound wealth as inflation eats up your gains.

On the next day, you and your friends decide to spend part of your prior day’s earnings, keeping $1.50 in your pockets. The day’s sales for everyone are $23.00, the GDP. The aggregate money supply remains at $29.00 ($23.00 + ($1.50 * 4)). Since the GDP fell, the velocity of money also fell from 1.00, as it had been in previous days, to 0.79 (23/29). While everyone has some money in their pockets, they are worried that sales have fallen off. Being smart consumers each friend is being prudent with their money, saving some, rather than spending all of it. This is the situation the U.S. finds itself.

I am using this short story to give you an idea of how the Fed stimulates an economy and how money works in an economic system. In the real world, the Fed provides money through banks in a more complicated process. Nevertheless, the basic idea is the same.

M2 Money Stock

Returning to our world and the current situation of the money supply, the Fed has injected a lot of money, doubling the monetary base. Is this money doing what it is supposed to do, i.e. growing the economy. Look at the M2 Money stock measures to get a better look. M2 includes additional measures of money including savings, time deposits, money market funds, and other close to money substitutes. All things being equal, the M2 should grow substantially if the monetary base doubles. There is more money around, so more of it ends up in these close money substitutes.

As the chart below shows, the M2 money supply has not leapt up as one might expect. In fact, in the last couple of months, the M2 turned down rather than ramp up. Going back to our formula for the money supply it looks like the velocity for money has pulled back some, negating the simulative affects of the Feds doubling of the aggregate monetary base.

This raises several questions. Will the velocity of money increase to help support the stimulus of the economy? Is the growth of the aggregate money supply sufficient to keep the economy from falling into deflation? Will the doubling of the aggregate money-base cause inflation to take off?

Only time will tell. For now, the decline in the velocity of money is partially off setting the rise in the monetary base. Going forward we need to monitor whether this will change, or is this permanent. With the velocity of money falling it reduces the current threat of inflation. On the other hand, it increases the potential that deflation could take hold.

Finally, the Fed itself is debating when it must “unwind” the expansion of the money supply. Federal Reserve governor Kevin Warsh indicated in a recent Wallstreejournal.com op-ed that the Fed might have to be more aggressive unwinding the easy money policy, much like it was aggressive in creating more money to begin with.

The falling velocity of money gives the Fed has some protection to maintain its easy money policy. This means the Fed can keep interest rates low for longer than some think. Remember, one of the Federal Reserve’s duties to is to pursue maximum employment. With unemployment likely to rise to ten percent, the Fed will not be in a hurry to raise interest rates to fast. As a result, I do not expect the Fed to raise interest rates until late in 2010. Moreover, when they do raise rate, it will be in slow measured steps as they try to drive unemployment down. They will be helped along the way by the falling velocity of money.

As investors, we need to monitor what the Fed says and does. For as long as Fed maintains its easy money policy stocks will do well.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2009 Hans Wagner

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