The Close Relationship Between QE and Stocks Will Shock You

The NASDAQ just booked its eighth positive week in a row, while the S&P 500 is up five consecutive weeks and counting. Both indexes are at their highest levels since April of 2022, which is well over a year ago. How can sensible investors make sense of this relentless rally?

Sure, we can point to the Federal Reserve’s recent “pause” in interest rate hikes. However, that “pause” is likely to just be a “skip” as the Fed indicated that there could be two more rate hikes later this year.

Besides, the rally in technology stocks started before that Fed meeting – though it’s undeniable that the market is extremely forward-looking nowadays. Speaking of technology stocks, they’ve evidently led the broad-based rally in large-cap stocks as financial traders continue to buy anything and everything related to artificial intelligence (AI).

And so, a frenzied market has enabled what I call “valuation dislocations,” such as NVIDIA having a P/E ratio of 222. People don’t seem to care about that now, though; they’re too busy celebrating NVIDIA’s entrance into the $1 trillion market cap club, which is getting crowded with tech names this year.

NVIDIA’s P/E ratio provides a stark indication that the company’s share price has rapidly outpaced its actual earnings. A similar example is Advanced Micro Devices (AMD), which has a P/E ratio of around 500.

Courtesy: Google Finance

Clearly, the corporate earnings of these tech firms aren’t commensurate with their high-flying share prices. Nevertheless, the short sellers have lost their shirts this year as traders continue to climb the proverbial wall of worry.

Additionally, anyone who abided by the old-fashioned market wisdom of “Sell in May and go away” has, so far, missed out on a sharp rally. Perhaps it’s an indication that old wisdom doesn’t apply to modern investing like it once did.

Or, maybe we’re just focused on the wrong contributing factors. Eventually, the weighing machine of the stock market will factor in corporate earnings, or the lack thereof. In the short to medium term, however, what really matters is the liquidity that’s provided to the big banks, and therefore the U.S. economy, by the Federal Reserve.

The quantitative easing (QE) that the Fed implemented from 2008 until 2020, went into overdrive in the wake of the COVID-19 pandemic. It’s no coincidence, surely, that the stock market took a moon shot as the pace of QE accelerated in 2020 and 2021.

Inflating the money supply had repercussions, of course, and today’s high prices in essential goods can be attributed to supply chain disruptions as well as unprecedented fiat money printing and spending. There was a brief period of quantitative tightening (QT) that put negative pressure on the stock market in 2022, but that’s in the rear-view mirror now and the Fed’s money printer that goes “brrr” is back on again.

Courtesy: MarketWatch

In case you’re still skeptical about the correlation between QE and the performance of large-cap stocks, take a glance at the chart shown above. Apollo Global Management chief economist Torsten Slok deserves credit for visually displaying the undeniably close association here.

Unless this close correlation is just a coincidence, then there’s no denying the cause-and-effect relationship between the Fed’s bond-buying activity and the S&P 500. Most likely, there’s a similar correlation between QE and the NASDAQ, presumably with the NASDAQ demonstrating leveraged gains compared to the S&P 500.

So now, it’s just a question of what to do with this information. Personally, my holdings aren’t too heavily correlated with the S&P 500 or the NASDAQ, so I’m not overly worried about any of this. You might have a retirement account or other portfolio that relies heavily on index funds, however.

No one knows exactly what the Federal Reserve will do next, but the central bank has a track record of returning to QE when all else fails. In other words, if you bet against the stock market because you expect the Fed to impose fiscal discipline for any meaningful length of time, you’ll probably be on the wrong side of the trade.

For me at least, all roads lead to selective stock picking and diversification via precious and base metals, rather than relying on index funds and hoping that the Fed avoids further policy errors. After all, if you’re counting on central bankers to do what’s right and reasonable, you’re liable to end up disappointed and broke.