Posted on April 16, 2012 by David Laidlaw

The equity markets enjoyed their best first quarter returns since 1998. While the Dow Jones posted a “modest” 8% increase, the NASDAQ surged 18%. Apple’s stock appreciated an astounding 47% during the first three months of the year and surpassed $500 billion in market capitalization.
The resilient US economy and improving employment numbers explain some of the stock market’s increase. During the 4th Quarter of 2011, the economy grew at a 3% rate. Economists predict this rate decreased to 2.0% during the 1st Quarter of this year.

Private sector employment has been improving for quite a while and the pace of hiring appears steady. Over the last three months (December 2011 to February 2012), the private sector has added 750,000 jobs. Additionally, the unemployment rate has decreased to 8.3% as a result of actual hiring rather than labor force contraction.

This rebound in employment may be the start of a virtuous cycle whereby employment gains spur increased demand for goods and services. This increased demand then causes employers to increase their hiring so that the process becomes self-reinforcing.
The past few months “feel” like a normal recovery and double dip scenarios appear less likely. Unscientifically, this is the first time in almost five years when financial panic seems
removed from everyday life.

Another explanation for the market’s rebound is that the Federal Reserve (Fed) has increased the money supply to such a high level that risky assets like stocks have nowhere to go but up. When the Fed buys bonds, it credits the accounts of the banks that act as the dealers for those bonds. This newly created money then enters the money supply through bank lending.

The chart displayed above illustrates the extent to which the Fed has been purchasing bonds. From a base of roughly $870 billion in August of 2007, the Fed has increased its purchases of fixed-income securities significantly so that the Fed now has over $2.8 trillion of assets on its balance sheet. The majority of these assets consist of US Treasuries and Mortgage-Backed Securities.

In 2011, the Fed bought 61% of all Treasuries issued by the US government. In dollar terms this is equal to an astounding $1.13 trillion of US Treasuries. It should be noted that the Fed is not acting alone in these purchases. The other central banks, including the European Central Bank, the Bank of England and the Bank of Japan, are all pursuing similar strategies such that in aggregate these central banks also own additional trillions of
dollars in assets of sovereign debt.

The rationale for these purchases is to stimulate the economy.  These purchases keep interest rates low, which entice more borrowers into the market to increase economic activity. The other reason for keeping rates low is to increase the demand for riskier assets such as stocks since rational investors understand that bonds provide very little return.

The current Fed’s actions are unprecedented and, therefore, the future impacts of the Fed’s massive balance sheet on the market and the economy are impossible to predict. A number of economists expect that these large balances will lead to accelerating inflation as more and more dollars chase a fairly steady supply of goods and services. Others believe that the Fed under Ben Bernanke’s guidance will be able to manage the purchases and sales of bonds without disrupting the economy or causing either inflation or deflation.

Another impact of the Fed’s buying could be the inflating of bubbles, including higher prices for such asset classes as stocks and commodities. In general, we do not believe that stocks have entered bubble territory given reasonable valuations and generally strong profits found at most public companies. However, the recent increase in prices may have been due, as much or more, to the Fed’s expansionary policies as improvements in employment. The market’s retreat in early April due to the Federal Reserve’s indication that more stimulus would not be forthcoming suggests that past bond purchases must have been at least partially responsible for the gains during the 1st quarter. So while things feel more “normal,” there are many vestiges of the crisis, such as the Fed’s balance sheet, that are far from the average.