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Quantitative Easing Effects:  Successes, Failures, & Surprises

NOTES: This study was published on August 1st, 2014, with the S&P 500 at 1925, and falling.  The market had a general concern that the forthcoming end of the QE3 program would pull support for the market, leading to a crash.  Our conclusions were nowhere near the consensus at the time.

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SUMMARY  (The short read. There are many moving parts in this Rube Goldberg-esque machine):  
  • In many respects, the Quantitative Easing programs were a failure.  We have no doubt that they served a valuable role in bailing out and unfreezing the mortgage market, pushing home sales and prices higher, but, as far as the rest of the economy goes, they missed their marks...
  • Most of the Federal Reserve's Quantitative Easing purchases ended up coming back to them as bank reserves, and did not become high-velocity money.  The Fed was essentially pushing on a rope, without the demand  for new money.  Thus, inflation and GDP growth have been modest.  We found no discernible effects on consumer lending (where reserves become money), money velocity, retail sales, durable good orders, personal income, jobs, or GDP.
  • QE purchases unexpectedly moved rates higher.  This was another unintended consequence, as they crowded out other market buyers.  This was contrary to their intention.
  • Much of the above-trend growth in the money supply was within M1 components (cash and checkable deposits), as, with near-zero interest rates, other short-term instruments were less desirable.
  • The Fed is holding over $4 trillion in long-term debt securities.  Were interest rates to normalize, they could be faced with multi-hundred-billion-dollar losses, if the securities were marked-to-market.  There is no politically-acceptable mechanism by which the Fed can book a multi-hundred-billion-dollar loss, so most of these securities will be held by the Fed to maturity.
  • With near-zero short term rates, and risk of losing net asset value  in longer-maturity notes and bonds, new money has been induced to flow to the stock market.
  • Animal spirits will eventually determine whether or not we are currently in a stock market bubble, but...
  • The economy, by many measures, is in a healthy position to keep moving higher.
  • Skip to Bottom Line below.

THE LONG READ  (but worth it):
Prior to QE1:
Pre-Crisis:  In late August, 2008, the US Federal Reserve had $909 million in assets on its balance sheet, primarily in the form of US Treasury bonds, but also debt securities of other various and sundry types: repurchase agreements, liquidity swaps, commercial paper facilities, etc.  The Fed's balance sheet was, by today's standards, relatively stable, creeping slowly higher in nominal terms, and nearly flat in real (adjusted for inflation) terms.  In September, 2008, the crisis was in full swing, and the Federal Reserve expanded funding activities.  The official Quantitative Easing  program did not officially start until December, 2008, but the liquidity operations started four months earlier.  For that reason, we start these charts in July, 2008, using the values on the Fed's balance sheet and the bank reserves held at that time as the baselines.  For years prior to August, 2008, both lines (Fed balance sheet assets and bank reserves) are almost flat, so omitted for this study.

Crisis:  In September, 2008, the Federal Reserve expanded funding activities, trying to provide much-needed capital into the markets.  Through its Term Auction Credit facility, the Fed provided loans (liquidity) to financial institutions around the world.  The Fed also "bailed out" and took control of AIG, providing an $85 billion credit facility (this number eventually grew to $112 billion, plus $70 Billion from the US Treasury Dept.), and took over Fannie Mae and Freddie Mac, injecting $100 billion to keep them afloat.  Other crisis-spawned emergency lending and asset purchases included assistance in the mergers of JP Morgan Chase with Bear Stearns, and, by the end of November, 2008, over $400 billion in what appears on the fed balance sheet as "Other Federal Reserve assets".  By the time QE1 launched, the Federal Reserve had already increased its balance sheet by $1.2 trillion, $584 billion of which went to excess bank reserves.  As you can see, since QE launched, nearly all  of the net QE purchases have gone to bank reserves, as the difference between the two has been nearly flat since before the QE purchases started.

TARP:  While the Troubled Asset Relief Program (TARP) was funded by the Treasury Department, it is important to include here, for many reasons.  First, the Fed and Treasury worked together in tailoring the program, with the Fed offering additional investment in some cases (e.g. AIG, Fannie, Freddie).  But, we must remember that the Treasury does not have the ability to create new money to disburse.  It is funded through taxes, and the selling of Treasury Bills, Notes, and Bonds (securities).  From August to December, 2008, the Treasury added over $1 trillion to the national debt through the issuance of new Treasury securities.  Since the Federal Reserve is prohibited from buying securities directly from the Treasury Department, it must purchase Treasuries on the open market, via its FOMC (Federal Open Market Committee) operations.  So, while Treasury was selling $1 trillion in securities, the Fed was providing over $1 trillion in liquidity to the market, via its purchasing of various securities and its Term Auction Credit program.   Essentially, the funding for TARP came indirectly from the Fed. We postulate that much of the cash received by the sellers, when the Fed purchased mortgage-backed and other securities, was used to purchase US Treasury securities.  In a collapsing financial market, US Treasuries were the safe haven.

TARP was signed into law on October 3, 2008, by President George W Bush.  It authorized the US Treasury to expend up to $700 billion to purchase "troubled", illiquid financial instruments from private institutions, in an effort to inject capital into a frozen market, improving the balance sheets of financial institutions.  Most of these assets were collateralized debt obligations, or CDOs (pools of mortgages of unknown values).  At the time TARP was implemented, these CDOs were nearly unsaleable, as the values of the mortgages contained were unknown.  Thus, many financial institutions were functionally bankrupt, as their balance sheets (with these assets "marked to market") showed insufficient capital to resume lending or other operations.  By paying over market  prices for these CDOs, the Treasury and the Fed allowed these institutions to resume operations, by becoming solvent again.  While the TARP program did not directly reimburse these institutions for losses on these assets, it did essentially "bail them out" of losses on their earlier risky wagers, by purchasing the troubled assets at above market prices, at a time when the institutions would have otherwise been insolvent.  TARP funds were also used to bail out the US auto industry, and to help homeowners refinance their "under water" mortgages at lower rates, and, at times, at lower balances.  The Dodd-Frank Act of July, 2010, reduced the authorized amount for TARP purchases to $475 billion.  Eventually, $422 billion would be spent under TARP, and the taxpayers would nearly break even (from: treasury.gov.  AIG: $12.5 billion loss.  Auto bailout: $6.5 billion loss   Mortgage programs: $11.5 billion loss (our est).  Bank bailouts: $35 billion profit.  Future cash flow indeterminable).  The Fed eventually booked a $10 billion profit on its AIG and Merrill Lynch investments.  Final profit or loss figures for the Fannie Mae and Freddie Mac purchases will not be known for some time, but the Fed is earning roughly a 4.9% return on its mortgage-backed securities purchases.

QE1:  Launched December 16, 2008, to purchase up to $600 billion in mortgage-backed securities (MBS), in an effort to add liquidity to the home mortgage market, and help reduce mortgage interest rates.  On March 18, 2009, QE1 was expanded by an additional $750 billion in mortgage-backed securities, and an additional $300 billion in US Treasuries.  The intention was to further provide support to the housing market, as well as to reduce overall interest rates, and support the job market.  Curiously, the interest rate on the 10-year Treasury Note increased  (bond prices decreased), despite the higher demand.  QE1 ended in March, 2010.  It is crucial to note that, while the Federal Reserve added over $1.6 trillion in mortgage-backed securities and Treasury securities during QE1, its balance sheet only grew by $200 billion, because it was repaid on most of the Term Auction Credit and sold many of the assets acquired in the pre-QE1 crisis period.  Thus, much of the first half of QE1 was a rollover from one asset class to another.

QE2:  With the economy stalling, the Federal Reserve launched QE2 on November 3, 2010.  The plan was to purchase $75 billion per month in long-term Treasuries, thereby reducing long-term (i.e. mortgage) rates.  In addition, on December 9, 2010, the Fed invested an additional $30 billion, which was a reinvestment of principal from previous MBS purchases.  QE2 ended in June, 2011.  Again, the interest rate on the 10 year Treasury actually increased  during this period, as the expectation of inflation inched higher.  Additionally, contrary to the intention of the program, mortgage rates also increased, mortgage lending slowed, as bank reserves increased dramatically.  QE2 was relatively short-lived.

"Operation Twist":  Perhaps the most interesting of the post-recession Fed programs, Operation Twist was announced Sept. 21, 2011.  After then end of QE2, the economy sputtered, and the stock market sold off.  But, with the CPI rising quickly in the months prior to Twist, the Fed had come to fear stagflation  (stagnant economy, high inflation).  Operation Twist was devised to help shore up the housing market, by driving mortgage rates lower, but without adding to the Fed's balance sheet.  The Fed decided to purchase long-term treasuries (driving long-term rates down by pushing bond prices higher), while, at the same time, selling short-term securities of commensurate dollar values.  The plan was balance sheet neutral, attempting to bring down long-term rates, while pushing up short-term rates.  As you can see in the charts above, the plan did not add to the Fed balance sheet, while 10-year Treasury and 30-year mortgage rates did fall.  Additionally, without the pumping  of the money supply, the CPI fell during this period, and "Expected Inflation" was benign.  The Yield Curve (difference between 30-year Bond and 3-month T-bill rates) actually fell until June, 2012, when the Fed announced an expansion of the program, and then started rising again.  The Fed never officially announced the end of Operation Twist, but it ran out of short-term securities in August, 2012.

QE3:  With the Unemployment Rate stubbornly above 8%, and benign inflation numbers, the Fed decided it had room within its mandate to provide even more liquidity to the markets.  On September 12, 2012, QE3 was announced.  The original plan was to purchase $40 billion worth of mortgage-backed securities per month, again, to stimulate the housing market and to try to increase employment.  Three months later, on December 12, 2012, the Fed added an additional $45 billion per month of US Treasuries, bring the QE3 purchases to a total of $85 billion per month.  Home prices and sales rose moderately during this period.  In March and June of 2013, Fed members hinted that the Fed may take action soon to start "tapering" the monthly purchases, eventually leading to the end of QE3.  As mortgage lenders started anticipating the end of the Fed's purchase of mortgage-backed securities, the housing market cooled, with both prices and sales rates tapering off, and mortgage rates rose.  QE3 is expected to be completed by October, 2014.

The long-tail taper of QE3:  You may notice in the "Fed Purchases vs. Bank Reserves" chart above that, since the latter part of 2013, bank reserves have not risen at as fast a pace as the Fed balance sheet, with a noticeable divergence from the clear correlation of the past.  This is due to a mostly-unreported program implemented in September, 2013, whereby the Fed decided to sell  Treasury securities to market participants, with the agreement to buy back the same securities at a later date, typically the next day, and at a predetermined price.  This essentially set a floor on the interest rate on overnight funds, as a de facto form of paying interest on bank reserves.  This appears in the data as a transfer from bank reserves to reverse repurchase agreements (RRPs), and encouraged banks to hold reserves in Treasuries rather than dollars.  So, while the Fed was purchasing Treasuries under QE3, it was selling the same to banks, money market funds, primary dealers, and Fannie Mae, Freddie Mac, among others.  Presumably, this enhanced the returns for the counterparties, as, by the time this program ends in January, 2015, the Fed will have several hundred billion dollars of these agreements on its books.  Thus, well after QE3 officially ends in October, 2014, the Fed will still have a large cash arsenal available to pump back into the market.  Although the official tapering of QE3 did not start until December, 2013, this de facto tapering program started in September, 2013, and will serve to give QE3 a longer, thinner tail than many have expected.


Pumping $3.5 trillion of new cash into the economy via bond purchases should manifest itself in higher bond prices (lower rates).  Surprisingly, the yields on the 10-year and 30-year Treasuries actually ROSE  during QE1, QE2, and QE3, and then FELL  after their completions.   This appears contrary to the economic laws of supply and demand, and it is contrary to what many "experts" tell us actually happened.  Why would bond prices fall  when a big new player (at one point, the Fed was purchasing up to 90% of all new dollar-denominated fixed-income assets) telegraphed trillions in forthcoming purchases?  Well, a few things happened...  First, with the added money-pumping, inflation expectations rose.  Additionally, these programs led the market to move forward its prediction of forthcoming Fed Funds rate increases.  Higher inflation with higher GDP growth should lead the Fed to raise rates sooner than it otherwise would.

This effect was exacerbated by the US Treasury's selling of securities during this period to finance the massive national debt and growing deficits, via stimulus and welfare/benefit programs.  With trillion-dollar deficits as far as the eye could see, bond traders had to anticipate the probability of higher rates at future Treasury auctions.  Thus, bond traders needed to demand higher returns on bonds, especially those of longer terms.  Checking the "10yr Treasury Auction Rate & Bid/Cover Ratio", and "Auction Bids Tendered and Accepted" charts above, we can see that bond purchasers offered to purchase an increasing number of bonds, but their bids were not accepted, as the offers were too low (the rates demanded were too high).

Most importantly, we must consider the following.  For bond holders who just sold their bonds to the Fed, where should they have put their cash?  Back into the same bonds?  Of course not.  At least, not at the same prices.  If they had wanted to hold long-term bonds, they would not have sold them.  If they were trading bonds, they would need to purchase the new bonds at lower  prices (higher rates) than those they just sold to the Fed.  Also, forward-looking bond traders anticipated that, eventually, the Fed would need to sell  all those newly-acquired bonds.  Trying to compete with the Fed's dumping of bonds at a later date would increase the probability of selling at a loss.  Compounded with the anticipated higher rates to come (via expected higher inflation, higher Fed rates, higher Treasury auction rates) driving down the net asset value of each bond, marginal bond traders soured on longer term debt securities.  In effect, through QE1, QE2, and QE3, the Fed crowded out other players in the bond market, driving down bond prices, and rates rose.  The marginal bond purchasers (those considering buying or selling) chose not to compete with the Fed at current rates, and left the market, or reduced bids for new purchases.  Those that remained demanded higher  rates.  We must assume that this phenomenon surprised even the Fed, as it was contrary to the intended result.  Remember this simple heurism: "Government spending ALWAYS crowds out private sector spending."

This is not to say that the Federal Reserve crowded out all other bond buying.  It is not necessary to drive away all other buyers to cause rates to increase;  It is only necessary to drive away the buyers at the margin, those who are deciding whether to purchase or sell bonds based on their expectations of future rate changes.  Indeed, since late 2008, the US Treasury has sold nearly $7 trillion (net) in long-term notes and bonds, with the Fed purchasing roughly $2 trillion of that amount.  With the crash in real estate and stock market values, millions of investors sought a safer haven, and took refuge at the US Treasury.  With short-term interest rates at near-zero, rate-seeking investors gravitated towards long-term notes and bonds.  This type of investor is less concerned with the rate of return, and more concerned with safety.  Thus, this influx of demand into the Treasuries market should have lead to higher prices and lower yields.  So, we have two countervailing inputs into the Treasuries market: The general market pushing yields lower, and the Fed pushing rates higher.  Taking a closer look at the "Yields and Rates" chart above, that is exactly what we see.

At the time of this writing, the Fed is caught holding the bag, with over $4 trillion of long-term  US Treasuries and mortgage-backed securities.  Were interest rates to finally normalize, the Fed could be facing a loss on those assets in the hundred of billions of dollars, if marked-to-market.  There is no politically-acceptable mechanism by which the Fed can book a multi-hundred-billion-dollar loss.  They will be forced to hold them to maturity, hiding behind poor returns.

Now, Operation Twist did have its intended effect of lowering long-term rates, as indicated in 10-year and 30-year bond rates and 30-year mortgage rates.  Since this plan involved the purchase of long-term Treasuries, while selling short-term Treasuries of the same dollar amounts, it was money-creation-neutral, and did not raise inflation expectations.

With QE3 tapering, annual budget deficits abating (shrinking from 13 digits to a mere 12 digits), and five years experience of benign inflation, inflation expectations have moderated.  

...and this pumping should have created higher inflation.  During the early stages of QE1, the economy was in recession, with the CPI falling into deflationary realm.  This was led by the dramatic fall in oil prices.  Throughout the remainder of QE1, and through QE2, there was visible correlation between QE and inflation.  Operation Twist was cash-neutral, and the CPI continued its slide.  We found little correlation between the extreme money-pumping of QE3 and inflation.  But, price inflation comes in many forms, and it is easy to see in the charts above that asset and equity prices have risen dramatically during the trillion-dollar-per-year pumping of QE3.  Overall, during this period, consumer price inflation has remained surprisingly low.  Perhaps this is because most of the pumping from the Fed has come back to it as excess bank reserves, and not as inflationary, high-velocity money.

Pushing on a rope.  Studying the "Fed Purchases vs. Bank Reserve" chart above, one can easily see the correlation.  Prior to the crisis, both the assets and bank reserves on the Federal Reserve's balance sheet were relatively flat in real terms.  The pumping started in August, 2008, prior to QE1, with the Fed providing over $1 trillion in liquidity to nearly-bankrupt financial institutions.  Much of these funds ended up as excess reserves at the member banks.  By the time the Quantitative Easing programs started, the banks were already flush with reserves, and not lending anywhere near historic levels.  As you can see in the chart, for each new dollar of assets purchased by the Fed during QE, banks reserves rose by same same amount;  Nearly all of the QE purchases ended up as bank reserves.  These reserves have the ability to become money in the future, as our fractional-reserve system of banking allows banks to loan businesses and individuals up to nine times the reserves held.  But, their being held as excess reserves really provides no stimulus to the economy, which is the intention of the program.  Why did banks hold the funds in reserve?  Well, first, we must remember that most of the reserve funds came from the long-term assets the sellers sold to the Fed.  For reasons discussed above, long-term bonds were not in favor, and short-term fixed income securities were at near zero rates (negative real rates).  So, where should the money have gone?  Surprisingly, in 2008, for the first time in its history, the Fed started paying interest  on reserves held, at a rate of 0.25% per annum.  This had the effect of discouraging banks from lending, as they could earn 0.25% annual return, risk-free, with little overhead or expense.  Additionally, it allowed banks to offer their customers rates-of-return on deposits that could compete with the near-zero rates offered by short-term Treasuries and money market funds.  So, for all the pumping, most went to bank reserves, and was not used to provide loans to fuel GDP growth.  The desire of banks to provide loans, in an uncertain risk and future rate environment, was not sufficient to get the funds into productive use.

Other than to excess reserves, to where did the money flow?  In the third and fourth charts above, we show the M1 and M2 Money Supply values, along with their trend lines for the previous five years.  The key point here is that the M2 Money Supply did grow faster than its trend, but almost entirely within its M1 components.  That means that all of the above-trend money growth was held in cash and checkable deposits, the most accessible, shortest-term holdings.  Savings accounts and money market components grew at rates similar to their previous trends.  Short-term rates have been too low to encourage some savers to move cash into savings accounts or money market funds.  The steady increase in M1 was not, as hoped, from increased bank lending, but from a migration from longer-term holdings.

What about the real estate market?  In the Fall of 2008, the mortgage market was frozen.  Mortgage-backed securities were nearly unsaleable, and lenders were unable or unwilling to lend.  We have no doubt that the Fed and Treasury purchases of nearly $2 trillion of mortgage-backed securities helped to unfreeze the mortgage market, and to restore real estate values back to reasonable levels.  That was a valuable and necessary outcome of Fed policy.  There is a strong correlation between home prices and mortgage rates, as one can see by studying our Home Prices and Mortgage Rates charts.  So, while QE1 was absolutely necessary to thaw the mortgage market, it, like the other QE programs, had the unintended consequence of raising  long term rates, as discussed above.  The program most beneficial to housing prices was Operation Twist, whose money-creation-neutral policy was able to bring mortgage rates down.  The home price cycle hit its trough in early 2012, and has peaked again.  Where prices head going forward will depend entirely on long-term rates.

And the all-important stock market?  The stock market loves the idea of new money.  Looking at the top two charts above, you will see a strong correlation between the QE programs and stock market prices.  Rallies began again at each new program (or hint of new program), and corrections occurred at the end of each program.  Also, with near-zero short term rates, and risk of losing net asset value in longer-maturity notes and bonds should rates rise as expected, new money has been induced to flow to the stock market.  The inflows of funds pushed stock prices higher.  Not wanting to be left on the sidelines, investors as a herd have followed the early money, pushing the stock market to all-time highs.

Does this mean we are in a bubble?  That is the all-important question: how to use this study going forward.  It certainly does feel  like we're in a bubble, with the market at all-time highs, and some stocks at seemingly unjustifiable valuations.  We recognize that the Fed will have pumped nearly $3.5 trillion new dollars into the economy by the time Quantitative Easing ends.  Indicators such as Robert Shiller's Cyclically Adjusted PE (CAPE) ratio have been flashing warning signs for many months, only to see the market head higher.  So, let's take a look at where we stand today:

  • Bank reserves:  With reserves at all-time highs, banks have the capacity to lend tens of trillions of dollars to businesses and individuals, via our fractional reserve system of banking.  What holds banks back from lending are an uncertain risk future, expectations of higher inflation and rates going forward, and the ability to earn profitable returns by simply trading with the Federal Reserve.
  • Reverse repurchase agreements (RRPs):  When the Fed ends its RRP program (essentially paying interest on pseudo-reserves), it will be pushing hundreds of billions of dollars back into the market, to flow where they may.  Many of these dollars will show up in the stock and real estate markets, and in the all-important consumer spending, leading to higher corporate profits.
  • M1 and M2 Money Supply measures:  With $11 trillion sitting near-idly in cash, checking, savings, and money market accounts, there is no shortage of funds available to increase spending.
  • Interest rates:  We remain with the lowest interest rates in generations.  Low rates facilitate economic expansion.  Higher interest rates can come from tight money supply (which we do not have), increased demand for loans (via growing economy), or inflation.  If and when banks are forced back to lending money to earn revenue, there will be immense competition, and loan rates should remain relatively low.  Banks are flush with cash.  We see no reason why they should be in any rush to raise rates on deposits.
  • Inflation:  We remain in a multi-decade decline in the Consumer Price Index, with rising Productivity.  With US energy production supplying most of our domestic needs, we expect no shock from energy prices.  There remains some slack in the labor market;  We expect no major labor-cost-push inflation until the unemployment rate gets below 5%.  Increasing minimum wage and health care costs will be managed by most companies via astute personnel management, maximizing productivity.  A growing economy, with increased bank lending (creating new money) can bring higher inflation.
  • Growth:  Notice that economic growth can lead us to higher interest rates and higher inflation.  But, that growth should manifest itself first in higher corporate earnings, which should push the market to higher levels than current.
  • Corporate earnings:  Many top publicly-traded companies continue to earn incredible profits.  The economic environment outlined above leaves room for even more growth.  The question becomes: How much are investors willing to pay for those future profits?  Currently, the Price/Earnings Ratio of the S&P 500 index remains higher than its historical average.  But, until better alternatives arise for investors to place their funds, the PE Ratio may continue to climb.  We do not see real estate as the alternative in this environment.  Nor commodities, nor bonds.  Until interest rates rise, the stock market will remain the investment vehicle of choice.
  • Yield Curve (more on rates):  A flattening yield curve has historically preceded a recession, which usually does not bode well for the stock market.  With short-term rates near-zero, the yield curve appears healthy.  We must remember that, through Operation Twist, its RRP program, and its paying interest on bank reserves, the Fed has been doing everything it can to prevent short-term rates from going lower, by setting a floor for bank and money market rates of return on their parked funds.  When this multi-faceted program ends, banks and money markets will be forced to look elsewhere for returns, such as to Treasuries.  Expect short-term Treasury rates to remain low.

  • Mortgage-backed securities:  The Federal Reserve's purchase of mortgage-backed securities has brought the mortgage and real estate markets back from the dead.  So, when QE3 ends, the mortgage market must return to normal.  We expect the lenders may be a little more hesitant to lend, as the MBS buyers will most likely be more discriminating in their purchases.  Home sales may slow, and rates may tick slightly higher, until a new equilibrium is found.  Wisely, the Fed has begun this wind-down slowly, via its "tapering" program.  We can see in our Home Prices and Mortgage Rates charts that this expectation has already begun.  Falling Treasury rates will help keep mortgage rates from climbing dramatically.
  • Interest Rates (again):  Despite the interest rate dynamics outlined above, several members of the Federal Reserve have announced that they expect to start raising short-term rates as early as the first quarter of 2015.  While we are confident that a Janet Yellen-led Fed will not raise rates too soon or too dramatically, we have to prepare for what may come.  The catalyst to their raising rates would be an inflation level above their 2% target.  Again, this implies economic growth before we get to that event.  However, higher rates give the stock market more competition for funds, flattens the yield curve, and can be bearish.  But, in this case, a small rate hike may actually be bullish, as it signals to the markets that the Fed sees economic strength, which may be too strong to control inflation.
  • Recession:  Despite all the best efforts of government, our Real GDP growth has been modest, and is expected to grow at just 2% this year.  We do not have far to fall to enter recession territory, and the stock market hates recession.  What could cause us to move to negative growth?  Primarily, a recession would come because of reduced demand, as "animal spirits" cause the herd to reduce spending, holding onto cash instead of making purchases.  We have seen reduced spending in some consumer electronics, where smart phones have replaced many consumer goods of the past (phones, cameras, computers, watches, notepads, calendars, music and video players, etc.), leading to the demise of several electronics retailers.  In this area, aggregate demand (AD), has decreased, despite much progress technologically.  If mortgage rates rise too quickly, we could see a real slowdown in the real estate market.  Besides the direct GDP impact of a slowdown in real estate, a spillover into consumer sentiment would be sure to follow, with continued slowing of spending.
  • Treasury Auctions (interest rates, again?):  The US national debt has surpassed $17.6 trillion, not counting unfunded liabilities, and with no end in sight.  At some point, Treasury securities may become less desirable, and rates may rise.  Were interest rates to normalize, the annual interest on the national debt would approach $1 trillion per year, dwarfing even our social spending programs.  Treasury rates would need to rise to sell all the new debt, starting a vicious feedback loop.  Were foreign countries to sour on US Treasuries, watch out.
  • Affordable Care Act, Minimum Wage increases.  As stated above, we do not expect these new mandates to have much effect on corporate earnings.  Most companies in the S&P 500 already provide health insurance to their employees, pay at higher than the minimum wage, and are very good at managing human resources.  But, there may be some layoffs, and for consumers whose rates have increased, less consumer spending.  There will be direct and indirect costs, coming as a surprise to many.  This may not be much of a shock, but, at 2% Real GDP growth, not much shock is needed to get to a recession.
  • Shock events:  The Middle East, Ukraine, Argentina, Greece, terrorist attacks, and asteroids.  Exogenous or "black swan" events are always a possibility.  At these levels, the stock market has a long way to fall.  But, short of hedging with some put options or similar, we cannot predict or plan for such events.  The market has a way of "climbing the wall of worry", continuing to push higher in light of all the negative possibilities.  That is, until they happen, and the herd heads for the exits.

BOTTOM LINE:  When we started this study, we expected to find evidence of a bubble.  We expected to find that the Fed overpaid for securities, pushed rates artificially lower, and pumped money into the market, creating a bubble that would pop upon the program's end.  Instead, what we find is an economy flush with cash, ready to be put to use once the Fed gets out of the way.  We find low interest rates, low inflation, and room to grow.  Sure, there are some negative possibilities.  There always are.  Increasing employment, consumer demand, and modest GDP growth, while keeping inflation tamed, will push stock prices higher.  Periodic, shallow corrections are healthy (we actually thrive on them here), to prevent the market from overheating, needing larger corrections.  But, in the final analysis, stock prices have room to grow.  Animal spirits, cooperate.