Are the European Central Bank and the Stock Market BFFs?

The suddenness of this week's stock market drop, coming after a meteoric rise this quarter, can't plausibly be attributed to the usual suspects. We are told that fears of slowing economic growth in China and a probable recession in Europe are the culprits. But those fears existed one, two, five and thirteen weeks ago. Why would the market drop now?

The 21st Century financial markets are all government, all the time. If you want an explanation for puzzling market activity, look at government activity. In the past three months, the European Central Bank has printed something like $1.3 trillion worth of Euros. Not that you'd get anyone at the ECB to admit it was printing money (an anathema punishable by torture on the rack in Europe). But the ECB would admit that it's been making a lot of three-year loans to European banks with interest set at 1%, while accepting as collateral all kinds of hinky paper (not necessarily excluding matchbook covers, burger wrappers and junk mail). The banks taking out these loans were facing potential credit crunches, so with the ECB making loans on terms that the private markets probably wouldn't extend, one needn't have a lot of imagination to conclude that the ECB has printed a lot of dinero in the past three months.

All that moola has to go somewhere. The borrowing banks deposited a lot of it back with the ECB, to boost their cash reserves against more handwringing over the European sovereign debt crisis. But one suspects that quite a bit of it may have gone across the pond into the U.S. financial markets, where stocks have been frothy because of improving economic data. And the fact that last year the U.S. Federal Reserve extended dollar-denominated credit lines to national central banks in a number of European nations would only make it easier to convert Euros into dollars that can be invested in U.S. stocks.

But recent signals from the ECB indicate that it won't be extending more of these three-year beauties. Since financial markets respond, first and foremost, to cash flows, the prospect of no more foreseeable money printing must be discouraging. All good things end eventually, and we know from recent financial history that no asset rises in value indefinitely. While money is fungible and definitively proving that the ECB's money print puffed up the U.S. markets isn't easy, the past twenty years demonstrate that the most reliable way to jack up stocks is for central banks to shovel money off their loading docks. And the same twenty years demonstrate that this isn't the path to lasting prosperity. So look both ways before diving into stocks.