As US corporations continue to report better than expected earnings for Q3, it's hard not to be upbeat and positive on the outlook for the stock market. Honeywell, Amazon, Kia Motors, and Microsoft all beat expectations as 77% of companies in the MSCI World group have exceeded projections. The reasons for this outperformance are multifactoral from extreme cost cutting via job losses to an improved revenue stream.
Money appears to keep flowing back into equities and the rally continues to extend. However, I believe there's more at work than meets the eye. From the research I did for my book, World Event Trading, the one over arching investment rule for equities over time is this: buy when the central bank is easing. It's not perfect, but it works.
- Slideshow - Central Banker Report Cards 2009
As most know, the Chinese have done what most around the world wish they could do. They have "encouraged" their banks to lend and lend the banks have. The Chinese had targeted 5 trillion renminbi of loan volumes and by the end of July over 7 trillion in loans have been provided. This is high powered, high velocity money. This lending has spilled out into all areas of the economy and has bled into the equity markets as well. Some research has estimated that as much as 20% has ended up buying stocks. Anecdotal evidence of pig farmers hoarding copper has shown up as well.
This leads me to contemplate that something similar may be occurring in the United States and the UK. The QE programs have essentially printed money and put it into the banking system. Unfortunately, this money is not high velocity as it has sat on the bank's balance sheets. The loan surveys for the UK, US, and some bank earnings reports have shown a drop in demand/volume of loans. However, we know that Goldman and Morgan Stanley reported large earnings due to trading. Is this related to cheap funds provided by the Fed?
More importantly, does it matter why stocks are going up as long as they go up? Not really, but we may be missing the trade here. Unlike China, velocity has remained subdued in the United States. If this were to change, then we could experience a similar market reaction as China did this year as money spills into speculation. This is not a market call for the next 5 minutes, but one for the next 12 months until the Fed tightens. It may help explain why stocks have not had a major pullback.
Granted, the Chinese are expecting to see inflation jump to 5%, but this is the price the Chinese are willing to pay to jack up the economy. Will the Fed be willing to do the same thing? With the US dollar under attack, the answer appears to be yes.