Why Stocks Can Go Higher Still

 

SPX 1,838.70

Stocks have continued to advance, virtually uninterrupted from the 2009 lows.  This rise continues despite the fact that the real world economy continues to look bleak.  While we receive data streams hinting that the economy is beginning to recover, many doubt that government numbers reflect the true picture.  There is little argument that "Main Street" continues to suffer while "Wall Street" flourishes.

Why are markets rising?  Most of us believe that the only reason is because the Federal Reserve has continued to add tremendous amounts of cash into the system.

Fortunately for us, The Federal Reserve does provide data showing us how much cash they are putting into the system.  Where does all this money go?  Much of it goes to the Federal Government through the Fed's monthly bond purchase program.  Even more goes to the banks.  Money is cheap.  One way that banks can use this money is to provide loans to businesses and individuals.  Unfortunately, with overall interest rates so low, why should banks risk capital.  Another use of Fed money is investing in markets.  We have seen this throughout most markets as cash has to be deployed - always. 

But are banks doing all that they can do with cash?

It certainly doesn't appear to be the case.  Fortunately for banks, the Federal Reserve Bank allows member banks to borrow cash and interest rates close to 0% and deposit it back at the Fed for a guaranteed return. 

It appears that the Fed has given banks the opportunity to write down their bad investments over the past few years and shore up bank capital.  I.e., continued "bail out."  It's quite possible that the banks still have devastating losses held in separate entities that aren't listed on their balance sheets.  The Federal Reserve Bank allowed banks to hold separate entities off their balance sheets. 

Recently however, there is talk that the Fed might stop paying interest on these excess reserves.  The banks warn that if this is the case, banks may start taking excess reserves held at the Fed and putting them into equities.  How high is high? 

Expect interesting times as the new Fed Chairman takes her seat at the end of the month.