FoggyTom

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High Stock Prices Make Sense Right Now

Maybe, sort of. Institutional Investors can’t borrow directly from the Fed, banks have to intermediate and they don’t always react the way the Fed expects. My theory is that leveraged investors (certain types of Hedge Funds) are impacted by changes in liquidity driven by Fed balance sheet changes. I wrote it out in this thread above.

High Stock Prices Make Sense Right Now

I’d be curious to know what you think about the theory Fed asset purchases are driving the market.

The link between Fed balance sheet and stock prices isn’t tight, but there seems to be a fuzzy connection—stock returns were higher than long run average during QE1-3, then went sort of sideways for awhile after 3 ended, after 2016 the global economy was on a better footing and stocks rallied until QT ramped up enough to matter, draining liquidity and the 4Q18 “correction” followed by resumed rallying coincident with “stealth QE” to mitigate illiquidity in the repo market. Then we got the C19 sell off, followed by QE4 > QE1+2+3 and stocks are ripping again.

The transmission mechanism is obviously not banks using the cash to buy equities, but rather increased availability of credit lowerIng the cost of borrow for leveraged investors. When liquidity was draining, it wasn’t a problem for until it hit a critical threshold where the cost to borrow no longer justified levering long for the marginal bet. At this point, someone decides it might be prudent to tighten up the risk exposure, which is effected by selling stocks and repaying lenders. In theory that ought to lead the cost of borrow to adjust down, but institutional changes after the GFC have made banks more risk averse and it’s possible, after the disruptions in the repo market, they decided to derisk too and a cascade ensues. Then the Fed buys $4tr of assets, the banks are flush with reserves, stock valuations are lower and so is the cost of borrow. This changes the calculus for leveraged funds (including derivatives related to equities like SPX futures) and they flip from net sellers of stocks to cut risk in the sell off and maintain margin requirements to net buyers.

Of course if we want to go all Ockham, money printing = devaluation -> inflation causing real assets like equities to catch a bid.