Why Size Matters, Fundamentals Don't, And What's Priced Into Stocks

QE3 is more like a longer but lighter version of QE1 Extension (given its size and composition) and as Morgan Stanley's Adam Parker points out, despite two outsized weeks of MBS buying the impact had a much more positive affect on HealthCare and Financials than on Technology and Discretionary sectors (though with oil prices already high this time - the negative feedback into the economy and equity markets is potentially different). However, as we noted recently, it seems fundamentals matter less than ever as S&P 500 return correlations to the Fed balance sheet are as high as ever and while hope springs eternal, unconventional policy remains a far more statistically significant driver of equity performance than European sovereign spreads, jobless claims, or even earnings revisions. Critically, the S&P 500 would be dramatically lower given over a year of rolling six-month negative returns if we adjust for the Fed's exuberance - and the symmetry of market-to-Fed reactions bodes ill for any deceleration in balance sheet expansion.


So it's QEternity or bust.


The Fed's effects on equity markets over the past two decades have been short-term in nature, highly dependent on the size of the move, and most importantly, symmetric - boding ill for any future balance sheet contraction or even reduced easing.


So far, the announcement of size and composition of QE3 looks like a light version of the QE1 extension


...during the QE1 extension, which at present seems most relevant to the QE3 announcement, Health care performed best, discretionary worst.


...but the 26-week rolling correlation of the change in the Fed’s balance sheet and the S&P 500 return was highest during QE2, and lowest last December when European tail risk began to decline.


...as we have commented many times recently, fundamentals and economics don’t matter when unconventional policy (or even dovish language) is being deployed. Sadly, there is some evidence this is right, given that since the start of QE, initial claims and earnings revisions, among other things, have been less associated with S&P 500 returns – and in the case of earnings revisions, perversely associated with S&P500 returns.

S&P 500 changes do not appear to be driven by changes in fundamentals; they have been inconsistently related to market returns during the QE periods and have generally been insignificant market return drivers.


as rather stunningly, over the past 26 weeks, two-thirds of the S&P 500 returns could potentially be explained by the Fed’s balance sheet changes...

and it is quite possible that performance of the market would have been negative without the unconventional policy...


It would appear from this final chart that a great deal of the current market is pricing in Fed action - as more than a year of rolling returns are now negative if it were not for the actions of Bernanke...


What Might Be Different This Time?


One big potential difference between today and prior periods of unconventional policy is the price of oil. Will QE3 drive further commodity price inflation? And, if so, will there be negative feedback into the economy and equity markets? We suspect so given the fragility fo global growth.


Source: Morgan Stanley