Stay Long Stocks Until...

...the Fed stops buying Bonds. It's as simple as that. The Fed has committed to purchasing $45 billion in treasuries and $40 billion in MBS per month for the foreseeable future. That's a run rate of ~1 trillion a year! The "Fed put" is real and I can prove it. Look at the following chart.

US Federal Reserve Total Assets data by YCharts

The plot starts on 11/25/2008 or the beginning of the first Quantitative Easing program (QE1). We can see there is a clear relationship between the Federal Reserve's balance sheet and the broader market (S&P 500). In fact the the correlation is ~92%. Furthermore notice that during periods where the Fed balance sheet has stabilized, the S&P experienced higher price volatility.

Chart number 2 plots the S&P 500 index level against the Fed asset level using data points from 11/25/2008 to present.

Notice the linear relationship between the two. In fact I ran a simple regression model which produced an R^2 of ~86%. That means ~86% of the variability of the S&P 500 price level is explained by the size of the Federal Reserve's balance sheet!

Simply put, if the Fed is continuing to to buy bonds and increase its balance sheet then keep buying stocks! My R code is provided below.

	library(Quandl)
	library(ggplot2)
	## import data using Quandl api collapsing SPX into weekly data ##
	spx = Quandl('YAHOO/INDEX_GSPC',start_date='2008-11-25',collapse='weekly')
	fed = Quandl('FRED/WALCL', start_date='2008-11-25')
	## run simple linear regression using adjusted close for SPX ##
	reg=lm(spx[,7] ~ fed[,2])
	summary(reg)
	## summary regression output ##
	lm(formula = spx[, 7] ~ fed[, 2])
	Residuals:
	Min 1Q Median 3Q Max
	-227.08 -58.30 16.48 65.16 157.53
	Coefficients:
	Estimate Std. Error t value Pr(>|t|)
	(Intercept) -1.450e+00 3.221e+01 -0.045 0.964
	fed[, 2] 4.731e-04 1.203e-05 39.343 <2e-16
	(Intercept)
	fed[, 2] ***
	---
	Signif. codes: 0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1
	Residual standard error: 87.67 on 254 degrees of freedom
	Multiple R-squared: 0.859, Adjusted R-squared: 0.8585
	F-statistic: 1548 on 1 and 254 DF, p-value: < 2.2e-16

view raw SPX_FedAsset Regression hosted with ❤ by GitHub

Bernanke's Bluff, Congress Gridlock, What Happens Next?

Did you fall for it? Market pundits and the general investment community gave the impression that Bernanke would announce the taper plan during September's FOMC meeting. While not an impossible event, the political and economic situation made it a low probability event. Here are my thoughts on why:

1. Bernanke's term ends January 31, 2014. A replacement has not been named and at the time one of the key front runners, Larry Summers, withdrew from the race. A policy change to the QE program which has been in place almost continuously since 2009 requires a stable Federal Reserve front office. At minimum market participants needed a clear replacement whose platform they can understand and factor into their investment thesis.
2. As we can see now, the federal government has fallen into partisan bullshit. Whichever "side" you're on is irrelevant but as a market participant the government shutdown has created uncertainty. At the time Bernanke and the Fed clearly saw the possibility of a government shutdown as a likely destabilizing force in the marketplace.  Uncertainty creates volatility and Bernanke has sought to avoid increasing volatility at all costs.

Not too complicated is it? The Federal Reserve hates volatility. These two forces are the most likely to add to the increase in volatility once the taper is announced. Therefore it is my opinion that any taper announcements with dates and clear reduction amounts will not be declared until the two aformentioned situations are resolved.

In short I expect no taper until a new chairman is named, and the partisan nonsense is resolved/delayed for another year.

As for what happens next, until the government shutdown has concluded expect more volatility. I am still investing/trading with a long bias. As long as the flow of funds from the Federal Reserve continues at the current pace, and economic data continues to show improvement declines in the broad market present opportunities to buy your favorite stock at a discount.