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Market Price Action is Discounting Another Round of QE

It appears that the two previous rounds of quantitative easing have maintained the coupling between commodity prices and stock prices. But this coupling broke in the third quarter of last year and this could mean that the rising stock market is either discounting another round of asset purchases or an economic recovery. Given that the economy is struggling, it appears that the former is the case.

On the monthly chart of the Dow Jones-UBS Commodity Index above I have marked with vertical lines the approximate starting times of QE1 and QE2. It may be seen that QE1 marked a bottom in commodity prices in early 2009 and then in late 2010 the market was offered a boost by QE2. On the chart below, the S&P 500 index is also plotted (scale not shown) and the two charts are changed to line graphs.

The thick black line is the graph of the Dow Jones-UBS Commodity Index and the red line that of S&P 500. It is clear that the two moved together since 2003 and although stocks peaked first in 2007, the two plunged together during 2008. The coupling was reinforced with QE1 and QE2 but after September 2011 it was lost again with stock prices rising and commodity prices falling. Either the stock market is discounting a recovery or another round of QE later this year. Given that the probability of an economic recovery is very low at this point, then the expectation for QE3 can justify this behavior of stocks. This further means that if QE3 never arrives, stocks will correct unless the economy picks up and we see a rise in commodity prices.

Unfortunately, this is how it will work in this century and may beyond: a coupling of commodity prices and stock prices. This is a vicious coupling that leaves little room for an effective monetary policy and one way it can be regulated so that economic decline does not imply certainty of a collapse is via quantitative easing, Of course, that cannot go too far and we must be ready to witness some vicious economic cycles in the future as economic recovery will mean paying higher prices for food, energy, housing, etc. with an economic bust following, then quantitative easing and so forth.  

Disclosure: no relevant positions.

Charting program: Amibroker (Charts created with AmiBroker – advanced charting and technical analysis software. http://www.amibroker.com/”)

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