Did the Fed Just Kill the Stock Market Rally?

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On the back of the worst daily decline since mid-November, stocks opened lower this morning, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average down 0.72% and 0.5%, respectively, as of 10:05 a.m. EST.

The fuel that is money-printing
The minutes of the Federal Open Market Committee's January meeting were released yesterday, and they hit the equity market like a bombshell. The minutes suggest a hawkish shift has occurred within the FOMC in regard to the latest round of quantitative easing, a.k.a. QE3, as members sharpened their focus on the risks associated with inflating -- and, ultimately, having to unwind -- the Fed's balance sheet. That balance sheet now exceeds $3 trillion and counting as the Fed purchases an additional $85 billion in securities every month.

As investors considered the possibility of an earlier halt to QE3 than had been expected, the effect on the stock market was immediate: Stocks sold off, and the S&P 500 suffered a 1.2% loss on the day. That was the largest daily decline since Nov. 14 -- one day before the index reached its bottom prior to embarking on the rally that achieved its high on Tuesday.


Was the reaction warranted? In the wake of the financial crisis, money printing and stock market gains appear to be tightly linked. The following graph shows the performance of the S&P 500 (red line) against the size of the Fed's balance sheet (blue line), beginning in last October -- the first full month in which QE3 took effect:

After an initial lag, the correlation looks pretty tight, and indeed, a similar pattern has governed the post-Lehman world. Here is the same graph, starting in the fourth quarter of 2008:

Are funeral arrangements in order for the rally that has pushed the stock market to within 2% of its all-time closing high? Not yet, in my opinion; I think the shift within the FOMC may be overstated. However, yesterday's decline is a glimpse of the losses that incautious bulls could suffer if the Fed ends quantitative easing ahead of expectations. If you keep your nerve, remain laser-focused on valuation, and trim overpriced holdings from your portfolio, you can expect to earn adequate returns over an equity-appropriate time frame.

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The article Did the Fed Just Kill the Stock Market Rally? originally appeared on Fool.com.

Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him @longrunreturns. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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