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What Did Quantitative Easing Do to the Stock Market?

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You may have heard it said that "The economy is one big market." Think of a bazaar in ancient times, with a huge mass of people walking slowly past countless stalls of vendors hawking everything from rugs to jugs to fruit and vegetables. People are buying and selling and haggling and negotiating. Through it all, money and goods are trading hands.

Imagine that everyone suddenly stops buying things. Every vendor wants to sell his or her wares, but no money is trading hands anymore. In short order, people wander away. Vendors pack up and leave. Soon, the whole place is a ghost town.

If that bazaar represents an economy, you've just imagined a recession like the global recession of 2008. What is a recession? When people don't spend money—whether they don't want to or they can't—everything slows down. (Okay, the technical explanation of a recession is a drop in GDP for two quarters in a row, but we can afford not to be economists here for a moment.)

What Does the Federal Reserve Do?

In the United States, the Federal Reserve controls the amount of currency in circulation. It works with the largest banks in the economy to add money in circulation (so there's more to spend: to stimulate a sluggish bazaar) or to remove money from circulation (so there's less to spend: to slow down an overheated bazaar). Their goal is to regulate capitalism and make it a little more predictable. The intent is to reduce the frequency and risk of bubbles and reduce the magnitude and length of recessions.

(The next interesting question is "How does the Fed make money?" Its goal isn't to make money, so it doesn't matter—but it does make money when it buys low and sells high and makes money on interest payments from the bonds it owns. Capitalism still works even with a fiat currency.)

What is Monetary Policy?

This monetary policy is controlling the amount of money in circulation. The main way the Fed does this is by setting the interest rate it charges when it lends money to banks. (See Why does the Federal Reserve lend money to banks?) The lower the interest rate, the cheaper it is to borrow money and the more attractive it is to spend that money. The bazaar heats up. The higher the interest rate, the more expensive it is to borrow money and the more attractive it is to save that money. The bazaar cools down.

What is Quantitative Easing?

If you think about it for a moment, you'll realize that the Fed can only reduce interest rates so far. If the bazaar is too quiet and the interest rate the Fed charges is zero percent, what then? How can the Fed encourage people to spend money rather than save it?

What is QE? Quantitative easing is the program under which the Federal Reserve began to spend money buying short-term bonds from banks. In other words, it began to purchase from banks rather than letting banks borrow money. Where did QE money go? To the banks!

Basic economics has established that when there are more buyers than sellers, the price goes up. Because there's more competition to buy these bank bonds (a new buyer is in town with lots of money to spend), the interest rates of those bonds go down (as sellers don't have to compete to make those bonds attractive; if there weren't many buyers, a seller would raise the interest rate offered to attract buyers). Why does quantitative easing lower interest rates? Because it increases the number of buyer dollars substantially!

Buying short term debt from a bank gives that bank money to lend out right away. In theory, this makes loans more likely to occur and increases the amount of money in circulation. In theory, this gives the bazaar a little jolt of energy, like a caffeine injection.

Yet that's only part of the story.

What Does Bond Buying Do to the Stock Market?

Where do you invest your money and why? You probably have a mixture of risk tolerance and the desire for a good return. Buying a US government bond or a bank bond is safe, but you won't get much return. When the Fed has an effective zero percent interest rate and where the Federal Reserve bond buying program (that's quantitative easing again), the interest rate paid by bonds will be very low. In fact, if there's any inflation at all, you'll lose money by investing in these short-term bonds.

That money has to go somewhere.

The Fed hopes some of it will get spent. The Fed wants it to circulate through the economy. Ideally a lot of it will go to things like small business loans and cheaper mortgages. A lot of those investment dollars went into the stock market.

It's no surprise that the S&P 500 Index had around 30% returns in 2013 and, with dividends reinvested, a 14% return in 2014. People wanted to buy stocks because they thought they'd get a better return than from investing in bonds. This isn't a surprise. When bond interest rates go down, stock prices tend to go up.

What Happens to Stocks when QE Ends?

What the end of quantitative easing means for the stock market is easy to predict: prices will go down temporarily. People see that 30% improvement in the market and want to take a nice profit. Sellers outnumber buyers and prices go down. Yet that's a temporary thing. Good stocks are always worth investing in, and in any economic condition you can find good stocks worth owning—if you're willing to look. Will money market rates go up? Eventually. Gradually. When and how depends on inflation.

In practice, there'll be fewer buyers than sellers, so bond prices should go down and interest rates will go up. In theory, that means less money going into stocks, so the market will likely reflect that: because buyers believe that there will be fewer buyers, they'll invest less, making a vicious cycle.

The good news for value investors is that this may expose more bargain stocks. (Does this mean that there are suddenly a lot of good banks to invest in? Doubtful; tighter lending standards, even informally and internal to banks, mean there's less appetite for risk in banks.)

Keep in mind the market's daily or weekly or monthly fluctuations aren't as important as buying great stocks and holding them for the long term. You can make a good return in the stock market regardless of quantitative easing or recessions if you're patient and thoughtful.