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Where Does The Market Go From Here?

Back in 2011, we showed the one and only correlation that has mattered to traders during the entire past 7 year period, in which capital markets lost their discounting ability and instead became policy tools micromanaged by central bankers, for an administration which equated the level of the S&P500 with policy success: that of the Fed balance sheet with everything else, and most certainly, asset and stock prices.

 

Then, just before the completion of QE tapering by the Fed, we showed what was also the only chart that has mattered since October, when the Fed stopped directly propping up risk assets when the Taper ended.

 

At the time, we quoted one of the few respectable strategists on Wall Street, DB's Jim Reid who said that "since the Fed balance sheet was used as an aggressive policy tool post-GFC, the graph suggests that the S&P 500 is well correlated with the size of the Fed balance sheet with the former leading the latter by 3 months. Given that the Fed have recently signalled that they will likely be finishing expanding their balance sheet in October, 3 months before that was July. This is important as virtually all of the mega rally in the last 5 years has come in the Fed balance sheet expansion periods. The other periods have been more challenging for markets."

Fast forward one year when after last week's furious selloff in stocks, the biggest in four years... stocks are precisely where they were a year ago. Just as we expected.

In fact, on Thursday, when the S&P500 closed at 2027, we merely remarked that based on its fair Fed balance sheet value, the S&P was "almost there", "there" being a level of just about 1970.

Almost there pic.twitter.com/UzNDDEibcB

— zerohedge (@zerohedge)

 

What happened on Friday? Precisely that: the convergence between the Fed's balance sheet and the stock market, which had traded "rich" to the Fed's BS for just under a year, finally took place, and the S&P is now trading back to where it should be, based on the Fed's $4.5 trillion in "assets."

And so, here we are, with the S&P500 back to where it was a year ago, and where it should be based on a Fed balance sheet which amounts to 25% of US GDP.

Which should come as a surprise to nobody: after all, it is now clear to even the most discredited self-proclaimed finance gurus well maybe not all) that it has all been a function of Fed liquidity injections into stocks (and withdrawals from other asset classes such as Treasurys which tend to flash crash on a monthly basis now).

The only question, now that stocks are back to their fair excess-liquidity implied value, is what happens next?

Because since it is once again shown that the S&P is all about the balance sheet, a rate hike, which make no mistake is tightening pure and simple, will simply accelerate the already violent decline. Which may be why Janet Yellen should indeed take Suze Orman's advice and "comment on rate increases" because suddenly the new generation of 17-year-old hedge fund managers is feeling just a little vulnerable.

Worse, the next leg up in stocks in this Pavlovian market, may well require the Fed doing precisely what we have said all along is the next inevitable step: QE4.... then 5... then 6...  and so on, until finally the helicopter money finally rains.