Plus episode excerpts: ETF Size, the Long-term Impact of QE, and Stock Market Inelasticity
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein, and this week we have a bonus episode. For almost 10 years, we've been running a premium membership community called Money for the Rest of Us Plus to help members invest with confidence and manage lasting wealth.

As part of that service, we provide a weekly premium podcast called Plus Episodes where we answer member questions and once a month share the audio version of our monthly investment conditions and strategy report. We have almost 500 plus episodes now. And this week on the podcast, we wanted to share excerpts from two recent Plus Episodes.

First, we discuss what degree the size of an ETF or mutual fund or the size of the fund sponsor matters. Is that something we should pay attention to when investing? Next, we take a look at the impact of quantitative easing and quantitative tightening on the amount of money in the system, how QE impacted inflation, how it impacted home prices and the stock market.

As a review, quantitative easing is when a central bank purchases government bonds and other assets in the secondary market. Finally, we will look at something called the inelastic market hypothesis, which seeks to explain why the stock market is so much more volatile than underlying changes in fundamentals, such as realized and expected corporate profits.

I hope you enjoy this preview of what we share each week on Money for the Rest of Us Plus, our companion podcast to the weekly free podcast. You can learn more about Plus membership at moneyfortherestofus.com.

Let's turn to a member's question. They were wondering to what degree, if any, a fund's total asset size and the fund family, whether that makes a difference. He gives the example, assuming two ETFs are well over, let's say, $75 million, so enough that the ETF is profitable for the sponsor. Does it make a difference whether one has $5 billion in

in assets and one has $500 million. Is there an advantage to being smaller, perhaps more nimble? It really depends on the asset class. If two ETFs had a similar fee structure and one had a smaller asset balance, let's say a couple hundred million dollars,

And the asset class they were both investing in was small cap, micro cap. I would prefer the smaller ETF because they can be more nimble getting in and out of less liquid securities. Now, it depends on the strategy. If it's an active strategy, that makes more of a difference. If it's more of a passive buy and hold approach, it's not going to make that much difference. And so it's important in a

assessing the size of an ETF to understand what is the strategy and is this a strategy with some type of capacity constraint? It could be an option strategy or it could be a variety of things, but think about what is the approach as we read the prospectus and would this be a strategy where the size and the number of trades would be the same?

would make a difference. And beyond that, probably not. Now, when we think about the fund family, is it better to invest with someone like BlackRock or Franklin Templeton or Vanguard? Does that make a difference? Some families specialize in, let's say, more option-based strategy, like Simplify. When I think about a fund family, I tend to...

focus on the fees. So Vanguard often has the lower fees. And you do find that with the larger families because they have greater economy of scales. They can spread their fixed costs over more ETFs and funds and then offer a lower expense ratio. So typically, the larger fund families have the lower expense ratio and that gives them an edge. In addition, and this is more difficult to quantify, the

The larger fund families often could have lower trading costs because, and we saw this with iShares back when I was an institutional advisor. I visited with them back then. They were still part of the Barclays family, but they could trade between the different products. Instead of going into the secondary market to execute trades, they could trade among their existing funds, the

essentially at no cost. And so that is an advantage of a larger fund family. Potentially those larger fund families have deeper relationships with the market makers that are there to make sure the price of the ETF stays in line with its net asset value. So by and large, for plain vanilla type asset classes, I prefer the larger fund families. And that's typically also driven by the

the expense ratio, but more niche strategies. Perhaps we do use a smaller fund family. It really depends on the particular approach, what is the expertise of a particular fund family. So we'll use Simplify again as an example. They have carved out a niche and expertise in more option-based strategies, esoteric strategies. And so it kind of depends on what you're looking at, but it is a factor. How big is the fund and how big is the fund family?

Next, I wanted to step back and take a look at the impact of quantitative easing, quantitative tightening on the amount of money in the system, how that impacted inflation, how it impacted home prices and the stock market. As a review, quantitative easing is when a central bank purchases government bonds and

and other assets in the secondary market. They typically work through commercial banks, so the commercial bank might have bought or owned treasury bonds, and then the central bank, such as the Federal Reserve, would buy those bonds from the bank. When a central bank, such as the Federal Reserve, does that, it will create reserves, which are effectively digital money, to purchase those assets. It's very much an accounting entity.

entry, but it is money creation out of thin air. For example, with the Federal Reserve, they buy U.S. Treasury bonds from a commercial bank or through a commercial bank. Those Treasury bonds are now assets on the left side of the Federal Reserve balance sheet, and the liability is the Reserve. Those

Commercial bank reserves. Reserves are basically funds that commercial banks hold at the Fed. With the reserves, they're the safest, most liquid asset that banks have. And they hold those reserves because they are required to from a

regulatory standpoint. They'll hold the reserves in case there's a big outflow from the bank, and they're just sort of liquidity that they get paid interest on. And so there's a monetary incentive to hold reserves because those reserves are being paid interest that is being credited from the Federal Reserve, and so that's income for the bank. When we think about quantitative easing then, if the federal government is

is running a balanced budget. So no new debt is being issued. There's only the debt trading in the secondary market. And then the central bank comes in and it buys some of that existing debt. What that does, it does increase liquidity, cash, in the overall economy because an entity sold those bonds that they held. It got sold to a commercial bank, ultimately to the central bank.

And the original holder of that debt now has cash. So they're more liquid and cash effectively was created by the Federal Reserve. But what hasn't changed is the wealth or the net worth within the economy. This was effectively an asset swap of a bond for cash, but there was no increased purchasing power wealth in the economy due to quantitative easing itself.

if there's a balanced budget. And oftentimes the studies that look at, well, is QE effective or did it do anything? If it's looked at just on its own, yeah, it doesn't seem to have much of an impact. However, if the federal government is running a budget deficit and those budget deficits tend to balloon during an economic crisis because unemployment is higher, those are also the time when central banks step in and start doing quantitative easing.

In that case, the federal government is issuing new bonds to plug the accounting hole because of the deficit. They're taking in less tax revenue than they're paying out in spending. Typically, they would issue bonds to cover that, but because the central bank, such as the Federal Reserve, is also in the market buying those bonds...

Right.

the system in the overall economy is increasing, which means we now have in aggregate higher net worth for the private sector and they have more cash to spend. And they did. And we can see that. If we look at the history of quantitative easing in the U.S., the Federal Reserve first announced quantitative easing in September 2008. At the time, the Federal Reserve, the assets on its balance sheet, which would include transportation,

Treasury securities was less than $1 trillion. QE was announced in November 2008. It ended March 2010. By the end of that period, there was $2.3 trillion of assets that the Federal Reserve owned, mostly Treasury bonds and mortgage-backed securities.

QE2 was from November 2010 to June 2011. That added another $600 billion in assets to the Federal Reserve's balance sheet, taking it up to just under $3 trillion. QE3 was announced in September 2012 to October 2014. That took the Fed's Federal Reserve's assets up to $4.5 trillion. And then it held about steady, at which point quantitative tightening was announced. In

in which the Federal Reserve announced that it would allow some of its bonds to mature without replacing them. During a quantitative easing regime, some of the bonds might mature, but the Federal Reserve or other central bank will buy a new bond to replace the one that's maturing. So QT started in October 2017. It went through September 2019, and it reduced the Federal Reserve's balance sheet by

by about $700 million. We did an episode that I'll link to in the show notes that looked at the impact of QT, and it didn't have a major impact on the economy because the federal government was still running a deficit. It just meant the amount of liquidity, cash in the system was being reduced. And so the money supply was reduced by $700 million. And

due to quantitative tightening. QT ended in September 2019, and we'll talk about what happened and why it ended, but basically the reserve balances that the banks held got too low to where they were unwilling to participate in money markets. They didn't have enough liquidity to invest in short-term securities outside of the reserves already held, and we saw basically a spike in

in repo rates, which are basically very short-term debt that has treasury bonds or treasury bills as collateral.

We discussed that in podcast episode 270 and what happened there. And so one of the unknowns is what is the adequate amount, or we'll call it ample reserves, that commercial banks need to hold so that we don't get some type of dislocation like we saw in the repo market in September 2019, where short-term rates spiked temporarily to over 10% because they're just

There was a gap. There wasn't enough buyers for the supply of these repos that were available. But let's look at sort of the long-term impact of QE. The first thing is because the Federal Reserve and other central banks are creating money out of thin air to buy these bonds, the amount of money in the system goes up. And we can measure the amount of money in the system by...

M2. M2 is a monetary aggregate and includes cash, checking and savings account deposits, and retail money market mutual funds. In 2008, right before QE was announced, M2 was $8 trillion. And the national debt held by the public was $5.3 trillion. And there was just under $1 trillion of assets that the Federal Reserve had.

By 2020, right before the pandemic hit, M2 had increased to $15.4 trillion. The national debt was $17.2. And then by 2022, after the big QE increase, we had M2 amount of cash and liquidity up to $21.7 trillion. And

And the national debt was just under $24 trillion. Now, it's okay that the money supply is increasing. The money supply increases as banks make new loans. That's how the accounting works. If I take out a loan, I promise the bank that I'll pay it back. And the bank electronically, digitally creates the deposit that backs money.

that new asset that they have, their loan receivable. That's how money is created, through bank lending. And that's a good thing in that we need enough money as the population grows, as the economy grows, the money supply should increase to facilitate transactions.

The problem with QE is the money supply increases too much. So back in 2008, if we take the M2 balance of $8 trillion and divide it by the U.S. population at the time of just about $306 million, that was $26,170 of cash per person in the economy.

The national debt per person was $17,288. Right before the pandemic in early 2020, the amount of cash per person was $46,000. And the amount of national debt per capita was $51,000.

And then we had the big QE spike with the pandemic taking the cash per person up to $64,205. So that was a 40% increase in cash per person since 2020. And overall cash per person was up 150% since 2008. Everyone has more cash. Now it's some people have much, much more due to inequality. But on a per person basis, 145% increase in cash per

per person. The national debt per person in 2022 was up to $70,000. The debt per person was up 310%. Now from 2008 to 2022, the overall inflation rate increased 45%. So we have cash increasing 150%, but inflation was only up 45%. Why is that? Because over

over time, businesses get more productive, more efficient at making stuff. And this harkens back to a point we made in our episode a month or so ago on currency debasement. In an economy where the money supply is not increasing at the rate that the population is increasing, they will see deflation. They'll see prices fall because businesses are getting more efficient at building computers, television, cars, agriculture. And

And that puts downward price pressure. So over time, even though the money supply increased 145%, inflation only increased 45%. Now that's still a big increase. Since 2020, we didn't have inflation up 21% in the U.S., the Consumer Price Index, and the amount of cash per person was up 40%. Now we have F&O.

Excess cash, some of it is showing up in consumer prices, but that cash, that increased cash, that increased net worth shows up in other assets. Home prices are not included in the inflation data, the actual home prices. What's included is rent of homes and what households believe they could rent their houses for. If we look at the median home price in the U.S., it's up 100% since 2008.

2008 from $222,500 up to $438,000. The median home price is up 33% since 2020. So here we have an asset that we call it asset inflation. Doesn't show up in consumer prices, but it is reflecting the impact of way more cash per person available. And that drives up asset prices because the supply of houses is not increasing as

as fast as the amount of cash in the system. The other thing that went up since 2008 is U.S. stock market. Now, the U.S. stock market reflects the benefit of productivity increases, which shows up in higher profits, but also inflation. So the U.S. stock market has risen 410% on a price basis since 2008, partly due to inflation, partly

partly due to higher profits, due to productivity increases, partly due to share buybacks, but also because investors are willing to pay more. The price-to-earnings ratio of U.S. stocks is significantly higher today than it was back in 2008.

Now we have a national debt held by the public of $27.5 trillion. That $27.5 trillion includes what the Federal Reserve owns, those Treasury bills and bonds, because the Federal Reserve is buying them in the secondary markets. So the government, U.S. Treasury, counts what the Federal Reserve owns as part of the national debt. The Federal Reserve has announced that the

They're slowing the rate of quantitative tightening, which they started in June 2022. And back then, the total treasury holdings of the Federal Reserve in June 2022 was $5.8 trillion. Now it's down to $4.5 trillion. So there's been a decrease of $1.3 trillion.

If we look at the money supply, the money supply actually shrank a little bit in the 2022-2023, and now it's been fairly stable because it's been helped by additional bank lending. Bank lending increases the money supply. QT reduces the money supply. And so we've had a slight, basically it's held fairly steady over the last couple of years. What we don't know is at what point will the Federal Reserve end quantitative taxing.

tightening, where it decides that, all right, there are ample reserves, adequate reserves. We don't want too little so that we get some type of market dislocation. In conclusion, then, what we learn is that quantitative easing combined with federal budget deficits leads to big increases in cash per person. That is what happened. We see it in the NRA.

M2 monetary data. We see it in the inflation data, consumer price index. We see it in asset prices, such as the median home price. We also see that those large budget deficits lead to more debt per person. We've done a number of episodes, a three-part series on the national debt. The national debt per person is now $70,000, $71,000. It was $17,000 per

per person back in 2008. It's increasing twice the rate of inflation. Again, inflation isn't increasing as fast because of productivity improvements over time. Each quarter, the U.S. Treasury announces how much they will issue in new debt

They'll finalize that number and do a release early in July. Ultimately, I'm not convinced QE is a good thing. At the end of the day, it drove up asset prices, inflation. Obviously, capacity constraints can contribute to inflation, but the money supply is growing faster than...

than the population, which means the currency is getting debased faster, which is why we have to hold assets that can keep up. That includes property, it can include stocks, but it also includes perhaps other monetary assets whose supply is not increasing as fast as the U.S. dollar, and that would include gold and Bitcoin.

So that's a review of what's going on with QE and QT. We'll see when the Fed ends QT, potentially by year end. Before we continue, let me pause and share some words from this week's sponsors.

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Next, our final topic is a member asked about the inelastic market hypothesis. This is a research paper, a theory put forth back in 2021 by Xavier Ghebre and Ralph Koijin. And what they were trying to figure out is why is the stock market so much more volatile than underlying changes in fundamentals in terms of corporate profits or changes in corporate profit expectations?

They did some research and they determined that when an incremental dollar is invested in the stock market, that it leads to a $5 increase in the price of stocks. And I'll link to the paper. You can kind of go through the analysis if you choose to. But basically, they're saying the market is inelastic. This is an economic term. Something is elastic if a small change in price leads to a significant change

in what's demanded. So if the price of something raised a dollar, people buy less of it, significantly less of it. Something's inelastic if the price changes, but the demand doesn't change very much. And the classic example would be cigarettes. People don't stop smoking when the price of cigarettes increases, at least not as many as something else.

If something's inelastic, if demand increases, then there's a big jump in price. And that's what these co-authors are saying. And the rationale is most investors are investing in ETFs, they're in mutual funds, could be pension plans. Their allocation to stocks is fairly stable. They're not changing their allocation of stocks as the price moves. They're inelastic.

Those that would be changing their stocks would be hedge funds or broker-dealers, and they point out that broker-dealers make up only about half a percent of the stock market, and hedge funds are about 4%. And so they're looking at it and saying, yeah, the theory is it appears that the market is volatile due to order flow. Incremental flows into the stock market or out of the stock market leads to increased volatility, more than

any change in fundamentals. I looked for follow-up papers and there weren't a ton. There was one by Bouchard who basically was able to replicate the work of Gabay and Koijin and found that, yeah, the stock market appears inelastic and so we get the volatility due to order flow.

What does that mean as investors? Well, it means the market's volatile and that volatility will show up in changes in valuations principally, whereas the longer-term drivers are going to be still the cash flow, the dividends. And is that cash flow growing as earnings grow? And those two, the dividends and earnings, are tied to economic fundamentals. That's why we're long-term investors in the stock market. We just have to recognize that it's a volatile asset class and

and it appears that much of that volatility is driven by additional demand flows going into the stock market because most of the investors are just there for the long term. I'd be interested in other conclusions that you might make based on that. The one thing that they suggested, the authors, was if stocks are so inelastic, then quantitative easing can be very effective if central banks started buying stocks because you get a big pop. Right.

Or if the U.S. decides to do a sovereign wealth fund and invest in stocks or invest Social Security in stocks. Now, I don't know if they'll do that or not, but that's something to consider. If there appears to be something politically that suggests big changes in demand for stocks, that could really send prices higher and valuations higher. That's our discussion on the inelasticity of the stock market.

I hope you've enjoyed these excerpts from our weekly Premium Plus episode. Again, we'd love to have you as a member of Money for the Rest of Us Plus. You can learn more about Plus membership and what's included in this premium membership community at moneyfortherestofus.com.

Everything I've shared with you in this episode has been for general education, not considered your specific risk situation, not provided investment advice. This is simply general education on money, investing in the economy. Have a great week.