Monetary Base & The Stock Market

The Fed has made its balance sheet available only back as far as 1989, but the St. Louis Fed
has compiled data for the monetary base, a very close proxy for the Fed's balance sheet, back
to 1918. History shows that when the growth of the monetary base, when adjusted for inflation,
turns negative on a yr/yr basis, trouble invariably follows for the US economy and the stock
market. The lead time between when the growth of the real monetary base zeros out and trouble
for the real economy and the stock market starts can be very short as happened over the late
1930's - early 1940's or very long as occurred during the 'roaring twenties'. My work over the
many years I have been at this game suggests that the continuing availability of private sector
credit is the deciding factor as to when removal of the Fed punch bowl starts to pinch the
economy and the stock market. Fast rising short term interest rates often telegraph trouble
ahead, but when private lenders are leery of the economy, the supply of loanable funds can
begin to dry up well before short rates begin a steep ascent during an economic expansion.

I have told of these observations, because as the Fed ends QE 3 in the weeks ahead, the growth
of the monetary base will likely flatten out as will the growth of the basic money supply. Then,
as an investor in the US, the Fed will no longer have your back. The easy money part of the
bull market will have ended. The risk / return profile for the market will be less favorable
because risk will rise given the growing dependence of the economy and stocks on the
generation of private credit in the system.

The current bull market need not end. The market will have to adjust to being credit driven as
opposed to being driven by monetary liquidity. Adjustment can vary from painful to nearly
seamless depending on how well confidence in the economy holds up and whether bankers
will continue lending now that they all know the Fed does not have their backs, either.

So far, investors have adjusted to the forthcoming new period by reducing holdings in most
smaller stocks and through increasing exposure to big cap names and Treasuries. So, most
stocks are oversold in the short run and it remains to be seen whether confidence will ebb
further or if players decide the economic prospects are solid enough to move some funds
back into the market.