Friday, 15 March 2013

A really simple explanation of how Quantitative Easing is fueling the rise in the stock markets.

Printing money

I have mentioned many times in this blog that I think the reason why stock markets are rising relentlessly while economies continue to languish is the result of Quantitative Easing. QE is the most up-to-date euphemism for printing money. 

The printing of money inevitably results in inflation: more cash chasing the same volume of goods leads to a rise in prices so there must be inflation somewhere. This is one of the first things a student of economics learns.

Consumer, commodity and property prices have remained relatively stable or falling until recently. And this while governments have been printing money continuously. Somehow the cash must be finding its way into the only arena where asset prices have been rising: stock markets. What I did not know was how the mechanism worked. That is until I came across an interview by Steve Keen.

Dr Keen showed the link between margin debt and the level of the US markets. This means that investors are buying shares on margin (another word for borrowed money) supplied by their brokers. 

The way QE works is this: governments buy bonds (which are long term assets) from banks and pay for it with newly-created money. The banks are now sitting on a pile of cash.

What the governments want, and their motive for printing money in the first place, is that it should be lent to companies to invest in their businesses and to consumers to buy goods from companies. In short, they hope it will be a shot in the arm for the real economy.

Partly because the banks are fearful of lending to customers who will subsequently default; and partly because people and businesses are uncertain that they will be unable to repay what they borrow, banks can't easily find borrowers. So they lend it to stock brokers who offer margin to their customers who buy stocks. They are willing to pay interest on money which they invest to make capital gains as their stocks appreciate. And the banks rub their hands as they earn good returns on the cheap money provided by the governments' QE.

The parallel between margin debt and the DJI shown in Dr Keen's chart is scary. The video is here.

I have noticed that there has been a flurry of adverts by lenders who specialize in lending to high risk borrowers. I wonder if QE money is finding its way into this market too: lending at extortionate interest rates to people who don't care whether they can pay their debts or not. It used to be called sub-prime; now it's called payday loans.

My portfolio gets a pounding

Part of the reason I have done so well in the last couple of months is the relentless fall in the pound. Since the beginning of the year it has slid from almost 1.64 dollars to the pound to 1.48 on Tuesday 12th March. And because more or less the whole of my portfolio is now in dollars I have benefited.

To give you an example, one of my best performing picks was BBY. I bought some of these for $11.9 per share, so each 100 shares cost $1190. In sterling that was £725.50 at an exchange rate of 1.64. The price had rocketed to $20.3 on Tuesday, increasing my dollar investment by 71% to $2030 per 100 shares.  The exchange rate was 1.48 so in pounds my shares were worth £2743, an increase of 89%.

As you can see on the chart,  the Pound's value enjoyed an abrupt reversal of fortune. This followed a comment yesterday by Mervyn King, Governor of the Bank of England, that the Bank was not trying to push down the currency's value. Those of you who like chart patterns will notice that the market anticipated the announcement by creating a doji formation two days before.

For me the change in direction has cost me money. BBY continued its rise since Tuesday and is now at $21.50 a 6% rise. Sterling has risen to 1.516 so my 100 shares  worth $2150 in dollars are worth only £1418 in pounds, a rise of just 3%.

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