Ever since the Dow broke the 14,000 mark and the S&P broke the 1,500 mark, even in the face of a shrinking GDP print, a lot of investors and commentators have been anxious. Some are proclaiming a rocket ride to the moon as bond money now rotates into stocks….[while] others are ringing the warning bell that this may be the beginning of the end, and a correction is likely coming. I find it a bit surprising, however, that no one is talking of the single largest driver for stocks in the past 4 years – massive monetary base expansion by the Fed. (This article does just that and concludes that the S&P 500 could well see a year end number of 1872 (+25%) and, realistically, another 28% increase in 2014 to 2387 which would represent a 60% increase from today’s level.) Words: 600; Charts: 3
So writes the Macro Investor in edited excerpts from his most recent post* on Seeking Alpha entitled S&P To 1872 From Quantitative Easing.
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The article goes on to say in further edited excerpts:
Comparison of S&P 500 Increase vs. U.S. Monetary Base Expansion[As mentioned in the opening paragraph,] I find it a bit surprising that no one is talking of the single largest driver for stocks in the past 4 years – massive monetary base expansion by the Fed [see chart below].
To estimate [the affect of the] monetary base expansion on the S&P 500, I did a simple calculation. Projecting the monetary base in the future is tricky, so I took the Federal Reserve Balance Sheet as a proxy. I plotted the S&P 500 against the Fed’s Balance Sheet on a weekly basis since the market bottom on March 2009 [see chart below].
(click to enlarge)
Effects of QE on Past S&P 500 Performance
From the [above] chart, it is clear that the Fed’s balance sheet is a good proxy for the monetary base [so] I ran a regression model [see chart below] to see how the S&P 500 has changed with the Fed’s balance sheet.
The R2 at ~77% is pretty high, which means that 77% of the price movement in the S&P 500 can be explained by changes in the Fed’s balance sheet….
Projected Effect on Future Levels of S&P 500
We know that the Fed will be expanding its balance sheet by at least $85 billion each month from QE, which means the ending balance will be ~$4T. Substituting in the equation, this means:
- a end year 2013 value of SPY of ~187, or a S&P 500 of ~1872, which means a 25% increase from current levels.
- If QE was to continue for 12 more months in 2014, the end 2014 value of SPY would be 239, or a S&P 500 of 2387, or another 28% increase in 2014
- which means a 60% increase from current levels by end of 2014.
Cross Checking Confirmation[The above] may seem like big increases, so let’s cross check this with historical P/E ratios. Even if earnings were to be flat for the next 12 months, at 1872, S&P 500 will have a backward looking P/E of 19. If earnings were to increase by 5%, backward looking P/E would be 18, and if they were to increase by 10%, backward looking P/E would be 17. As a comparison, the last time the S&P 500 was at 1500, the backward looking P/E was 17.6 so these numbers are not unrealistic at all.
How to Maximize Profits
How can an investor profit from this trend? Today, I bought January 2014 strike 115 calls on the 3x leveraged ETF on SPY (UPRO) for $11.5. If the S&P increases by 12.5% from this level (half of the predicted 25%), then UPRO will end the year at ~140. This will mean about 120% return on the calls in a year. Breakeven will require about 7-8% increase in the S&P 500, which I expect to come before summer.
This market, fueled by massive amounts of liquidity being pumped by the Fed, has legs.
Editor’s Note: The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
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