Is Fed Buying Behind the Stock Rally?

Following the cash
Here's the line of reasoning: U.S. stocks gained $6 trillion in aggregate market value starting in mid-March. According to TrimTabs, historically, increases in stock market value require a net cash inflow into stocks equivalent to 10% of the increase, or $600 billion in this instance. However, the firm couldn't trace the origins of anything close to that sum from among traditional market participants. The following table summarizes TrimTabs' findings:

Source: TrimTabs.

If TrimTabs is right, we're far short of the $600 billion needed to fuel the rally we witnessed. But would a central bank intervene directly in its equity markets? Although unorthodox, this has occurred (at least) three times -- in two advanced economies, no less -- since 1998.

Hong Kong shuffle
During the 1998 Asian currency crisis, the Hong Kong Monetary Authority (HKMA) purchased US$15.1 billion worth of Hong Kong shares -- approximately 6% of the value of the entire market -- to stabilize markets. At the time, the U.S. Treasury and then-Fed chief Alan Greenspan roundly criticized Hong Kong's action. The Hong Kong government ultimately bundled the shares into an index fund that they sold to the public in the course of realizing US$14 billion in profits.

Last year, starting on Feb. 23, the Bank of Japan (BOJ) purchased 207 billion yen (approximately billion $2.2 billion) in bank-held shares, with a target investment of 1 trillion yen. Between 2002 and 2004, the BOJ also bought stocks as part of a 3 trillion yen-buying program, which it started to unwind in 2007 -- shares sales were halted a year later as Lehman Brothers collapsed.

Going "all in" on bank stocks
Comparing the two, the BOJ's intervention looks like the better model for a hypothetical Fed action. I'd be more inclined to believe that the Fed implemented a smaller, more focused operation consisting in buying bank shares on the open market to complement its TARP investments. Last March, with all eyes on the banking sector and bank stocks suffering devastating losses, the Fed could have reasoned that a turnaround in bank stock prices would have a significant positive impact on market sentiment.

In aggregate, U.S. financials gained $1.3 trillion in market value from the March 9 market low through the end of 2009 (see table below). According to TrimTabs' "10%" rule of thumb, that increase would have necessitated just $130 billion of new cash invested in the sector -- a trifling sum in this era of trillion-dollar bailouts.

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

Regardless of where the cash came from, one thing is certain: Financials led the rally. From its low, the S&P 500 rose 65% in 2009; the KBW Bank index eclipsed that performance with a 118% gain.

Ultimately, though, this is all just conjecture. I think the likelihood of a Fed share buying campaign is very low, and here's why: Both the Hong Kong and Japanese central banks publicly announced their plans to buy equities; if the Fed has intervened in the stock market, it has done so in total secrecy. At a time when the central bank is already facing unprecedented backlash concerning its role leading up to and during the crisis, this would surely amount to political suicide if it were to surface. I don't think it happened -- but I can't rule it out entirely.

Conjecture is fleeting, tangible risks remain
Either way, I've warned Fool readers repeatedly about the risks of owning low-quality, speculative financial shares, most prominent among which are three companies that are on official government life support: AIG (NYSE: AIG), Fannie Mae and Freddie Mac. In all three cases, the government's exit strategy is a mystery; on Christmas Eve, the U.S. Treasury announced that it was removing the $200 billion caps on the funding it can provide Fannie and Freddie over the next three years. The risks to the owner-speculators of these companies remain substantial.

© 2009 UCLICK L.L.C.