Here's a Reason Why Stocks Will Go Higher

Ankush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The modest correction in the U.S equity space is well and truly over. Although the recent sell-off caused the major equity indices to trade well and truly below their highs, yet the markets have recovered well and we have seen yet another full fledged reversal.

Although we have had a below par GDP revision, other aspects seem to be in place. Consumer confidence has been on the rise for quite some time and so has the housing market. These surely point towards a recovering economy which is a good proposition for stocks.

Having said this, it is prudent to note that, the markets, while recovering from the recent plunge, seem to have priced in the QE (quantitative easing) 'taper talks' of the Federal Reserve.

QE and Equity prices- From no correlation to high correlation

Without a doubt the Fed's intervention has been the single biggest catalyst for the uptrend in equities since the sub-prime mortgage crisis of 2008-09. In fact without the monetary easing, it is actually quite hard to imagine a recovering economy and a bull market post crisis.

Chart 1

<img alt="" src="http://static.cdn-seekingalpha.com/uploads/2013/7/16/saupload_d9dd55396183b88e27c06f7b13422354.png" />

US Federal Reserve Total Assets data by YCharts

As we can see from the above chart depicting the Federal Reserve's balance sheet size with the SPDR S&P 500 ETF (SPY), Quantitative Easing has been instrumental in giving a boost to equities. This holds true right from the first round of QE post the mortgage crisis. In fact I have purposely created this chart from a period just prior to the monetary easing programs, just to highlight how two un-correlated phenomena became so highly correlated.

It is true that before the launch of QE1, the Fed has a fairly stable balance sheet. However, with all the easing in place it has swollen to gigantic proportions. Nevertheless, it has also caused equities to rise across board. Of course, given the damages posted by the mortgage crisis, a decent damage control act was well and truly required!

Further analysis on the impact of the monetary easing on the equities shows that the two entities have become highly correlated over the course of time. The following table throws light on the increasing correlation levels between the two.

Table 1: Correlation Between equity prices (S&P 500) and Fed Balance Sheet

<table> <tbody> <tr> <td> <p><span>Year</span></p> </td> <td> <p><strong>Since 2006</strong></p> </td> <td> <p>Since 2009</p> </td> <td> <p>Since 2010</p> </td> <td> <p>Since 2011</p> </td> <td> <p>Since 2012</p> </td> <td> <p>Since 2013</p> </td> <td> <p><strong>In 2014 (Forecasted)</strong></p> </td> </tr> <tr> <td> <p><span>Correlation Co-efficient</span></p> </td> <td> <p><strong>-8.82%</strong></p> </td> <td> <p>90.79%</p> </td> <td> <p>84.74%</p> </td> <td> <p>70%</p> </td> <td> <p>85.59%</p> </td> <td> <p>91.15%</p> </td> <td> <p><strong>96.70%</strong></p> </td> </tr> </tbody> </table>

The once negatively correlated entities have come a long way in showing an increasing correlation trend. In fact a simple extrapolation reveals that the correlation will increase to as high as 96.70% in 2014 if the Federal Reserve continues to print more money (which they are most likely to continue doing).

This is primarily because even though unemployment levels (the biggest reason behind the monetary easing) have come down substantially, it is still way beyond the Fed's target of 6.5%. Also, with inflation levels still subdued, we are sure to see this correlation trend increasing further into the year.

Of course, these correlation levels will inevitably reduce as the Federal Reserve begin to scale back the monetary easing. This will cause the equity markets to be back on its normal course of action and start discounting economic fundamentals more than central bank easing. But the big question remains when? A calculated assessment surely points hints at end 2014 or even mid 2015. Unless this happens there is still more money to be made in this market on the long side.

For investors seeking to play the long position in equities in a basket format the following ETFs can  be interesting choices:-

Apart from the mega-cap and cost-effective SPDR S&P 500 ETF (NYSEMKT: SPY), which replicates the performance of the S&P 500 index and charges investors just 9 basis points in fees and expenses, I would like to highlight 2 other ETFs from the large cap space.

Launched in May of 2000, the iShares Core S&P 500 ETF (NYSEMKT: IVV), has a massive asset base of $44.66 billion. It charges investors just 8 basis points in fees and expenses and mimics the performance of the S&P 500 Index. Although very similar to SPY, it has a huge advantage over its SPDR counterpart.... size.

While its true that investors might be apprehensive about the gigantic asset base of SPY and be reluctant from investing in it. On the contrary IVV can prove to be an extremely good alternative although there is very little to chose from the two ETFs in question.

Also, a lower expense ratio is surely an added advantage for the fundamental buy and hold investor as it goes a long way in maximizing returns over the longer term. Also, it is worthwhile noticing that it has a correlation of more than 99.5% versus the S&P 500 which suggests that it does an extremely good job in tracking the performance of the index.

Another way of gaining exposure in this segment is the iShares Russell 1000 Growth ETF (NYSEMKT: IWF). The product is appropriate for investors seeking a large cap flavor but not limiting their investments to the universe of 500 stocks in the S&P 500 index.

Instead, the ETF provides a comprehensive broad based exposure tracking the 1000 stocks from the Russell 1000 index. The ETF employs growth strategy of investing and selects stocks which have a high price to book, high price to earnings and high earnings growth potential.

Compared to the other two, IWF charges a slightly higher expense ratio of 20 basis points but surely the larger universe of stocks with comparatively lower market capitalization, which creates an added scope for above par returns. Although the risk involved is also slightly higher.

While it may seem that the markets are extremely over heated at this point, yet investors should also note that placing bets against the Federal Reserve has always been a losing game. Having said this it is also important to know the choices available and these ETFs surely are in-expensive but effective avenues to play the surge.


Ankush Shaw has no position in any stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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