One well-known investing maxim is “don’t fight the Fed.” We think the reason for this is that monetary policy never works the way it’s described in textbooks. The standard description of monetary policy states that the central bank buys an asset and creates bank reserves, and then those reserves are lent out and recirculated to increase the money supply and generate economic activity. Sometimes that activity influences prices, and sometimes it creates real growth.

However, the standard description is not a reliable way to think about monetary policy and investing. In fact, the Fed works with a network of primary dealers (21 large investment houses) to buy and sell assets. It’s the decision of those dealers that directs the flow of reserves into the markets. Expansionary monetary policy doesn’t lift all boats in the economy equally. Instead, it creates waves, and the financial markets are usually the first place those waves slosh around. From 2000 to 2003, expansionary monetary policy first went into hard assets, including real estate. From 2007 to 2009, expansionary monetary policy flowed into Treasuries and other perceived safe havens. Where it flows and how much it influences prices largely depend on the current state of the market environment. From 2000 to 2003, hard assets were favored because we were in an environment with strong expectations and severe disappointments from the bursting of the tech bubble. From 2007 to 2009, the credit crunch led investors to flee to safe assets. But today’s environment is much different. That’s why we think the money is flowing into stocks and, to some extent, into commodities.

The Fed’s plan to purchase an additional $40 billion in MBS, along with the $45 billion in Treasuries it is purchasing as part of Operation Twist, could expand the Fed’s balance sheet by 12% for the rest of 2012. Most of those purchases are probably just going to create additional excess reserves at banks. That money can slosh around throughout the day as long as the money ends up back at the bank by the end of the day. That’s one way the Fed’s program can lead to changing prices of investable assets. Another is simply because the Fed’s purchases are likely to keep MBS yields lower than they otherwise would be. That changes the relative risk/reward profile of other investable assets, pushing investors into those assets. Consequently, even though we think “fair value” of the S&P 500 Index is close to 1,420 based on the economic fundamentals, that value could move closer to 1,505 when you factor in Fed activity.

A shift in attitude
Longer-term, we think the consensus that has built up over the past few years—the one insisting that all the excesses of the last few decades eventually need to be paid for—will change. The consensus is likely to shift to one of, “it’s being dealt with.” The programs and reforms in Europe and the likely debates, discussions, and decisions to be made in the U.S. over the next year or two could help change investors’ perceptions. We believe a shift in position from “there’s a problem” to “it’s being dealt with” could lead the markets higher, even if the economy doesn’t keep pace.

Of course, there are risks to our outlook, the first being that politicians won’t actually deal with problems even after the elections. While possible, we don’t think the voters will stand for that. Second, the Fed could pop the bubbles it’s inflating if inflation runs hotter than 3% and unemployment fails to drop below 8% by the end of the year. Such a scenario would force the Fed to decide between losing credibility by appearing unable to tame the beast of inflation or disappointing investors by abruptly curtailing its bond-buying program. We think the Fed would err on the side of disappointing investors rather than destroying its reputation. Third, conflict in the Middle East could change the entire investing climate. While that isn’t something we can forecast, it is certainly a reason to remain cautious.

The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock's weight in the index proportionate to its market value. You cannot invest directly in an index.