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How Janet Yellen Will Affect The Stock Market

Chairwoman Janet Yellen

Why Market Watchers Want To Know About Federal Reserve Chairwoman Janet Yellen

President Obama has officially nominated current Vice Chairwoman of the Federal Reserve Janet Yellen to replace Ben Bernanke as the leader of the Federal Reserve, which has all stock market participants wondering how Janet Yellen will affect the stock market?  While it may seem like an overused cliché, “Don’t Fight The Fed” is actually a very wise piece of stock market trading and investment advice.  The reality is that Federal Reserve monetary policies have a significant impact on the movement of the stock market over time; and therefore, understanding how the incoming Federal Reserve Chairwoman will likely conduct monetary policy is very import to make sound trading and investment decisions going forward.  Luckily, Janet Yellen is a very well known figure at the Federal Reserve, so understanding her monetary philosophy and her likely impact on the stock market does not require a lot of guessing.

The Federal Reserve’s Impact On The Stock Market

Federal Reserve
The monetary policy that the Federal Reserve puts in place has a significant impact on the movement of the stock market over time.  The Federal Reserve can affect the stock market by changing short and long-term interest rates in the United States, and by either adding or removing money from the United States economy.  While the stock market is notorious for undergoing short term gyrations in price due to numerous economic variables, over long periods of time, the backdrop of Federal Reserve’s monetary policy affects the movement of the stock market, either higher or lower.

When the Federal Reserve is in later stages of the process of tightening monetary policy in response to inflation pressures by raising interest rates and draining liquidity from the banking system, the stock market tends to eventually level off or enter a bearish downward trend, as economic growth slows and corporate earnings decline.  When the Federal Reserve is in the process of loosening monetary policy in response to slow economic growth by lowering interest rates and adding liquidity from the banking system, the stock market tends to enter a bullish upward trend, as economic growth increases and corporate earnings grow.

Many stock market observers credit the Federal Reserve’s quantitative easing program and low interest rate policies with contributing to at least 50% of the stock market’s huge advance since the March 2009 low.  The actual impact on the stock market may be significantly greater than a 50% increase in valuation, since the Great Recession of 2008 and 2009 may have turned into a prolonged economic slump in the absence of the Federal Reserve’s quantitative easing program and low interest rate policies, which could have caused a prolonged bear market in the stock market.

How Janet Yellen Will Affect The Stock Market As Federal Reverse Chair

Federal Open Market CommitteeThe Federal Reserve Chairperson essentially sets Federal Reserve monetary policy because the rest of the Federal Open Market Committee (FOMC), which is the body that votes on Federal Reserve monetary policy changes, almost always follows the Federal Reserve Chairperson’s lead.  This is why it is so important to understand how Janet Yellen will affect the stock market.

Janet Yellen’s public statements indicate that she is inclined to use Federal Reserve monetary policy to lower the unemployment rate.  This means she is likely to continue and possibly expand quantitative easing and other easy money polices, until the unemployment rate reaches the Federal Reserve’s target threshold, which is 6.5%.  With the unemployment rate at 7.3% in August 2013, and a 6.5% unemployment rate not forecast to occur until later in 2014, it is likely that Janet Yellen will continue easy money polices through at least the latter half of 2014.  This is good news for stock market bulls, as it means low interest rates and continued Federal Reserve liquidity injections into the United States economy will last for six months to a year longer than what was likely under Ben Bernanke and the stock market bull run will likely continue well into 2014.  Look for the stock market indexes to set new all time highs with Janet Yellen at the helm of the Federal Reserve.  The stock market rally will be driven by low interest rates, quantitative easing, and higher rates of economic growth due to dovish Federal Reserve policies under Janet Yellen.

What Wall Street Needs To Be Careful About Regarding Janet Yellen

While Janet Yellen’s easy money and accommodative monetary policies as head of the Federal Reserve policies are likely to push stock prices and stock market indexes higher than their 2013 peaks, there is the real threat that a Federal Reserve induced bubble may form in the stock market.  A stock market bubble would be characterized by stock valuations that become exceedingly rich, in which the average price / earnings ratio (p/e ratio) for stocks skyrockets to over 20 (which is significantly higher than the long-term p/e ratio average of 15).  While a surge in stock prices under a Janet Yellen Fed would be widely popular and celebrated while it is occurring, a stock market bubble is not a good thing for the economy in the longer term, since stocks have a tendency to revert to mean valuations over time, as investors question the value of stocks trading at average p/e ratios above 20 when earnings growth slows or goes negative.  If the reversion to the mean occurs quickly, it is called a stock market crash, which can have serious implications for consumer confidence and economic growth.

One not so well known fact about Janet Yellen is her propensity to take a hawkish monetary policy stance when inflation reaches levels above the Federal Reserve’s target rate.  Based on her past policy positions, it can be assumed that as Federal Reserve Chairwoman, Janet Yellen will not hesitate to raise interest rates and drain liquidity from the economy to head off inflation, if inflation pressures appear to be building.  While the stock market can handle some increases in interest rates and removal of liquidity, once the Federal Reserve’s tightening reaches a certain level, it creates a serious headwind for stock prices, and a correction or bear market sell-off usually occurs.

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One Response to “How Janet Yellen Will Affect The Stock Market”

  1. chitra says:

    Thanks for the post. Waiting to see the policies adopted by janet yellen and its impact on the stock market.


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