Possibly the most important factor in the market today is not earnings, unemployment, or any special sector. It is the Federal Reserve and its campaign to support the stock and credit markets with intense buying through its Permanent Open Market Operations, or POMO.

Tom McClellan, a veteran technical analyst who publishes the insightful and entertaining McClellan Market Report , has done a very interesting study of the effects of POMO, which are publicized as they occur at the Fed’s website. And he has given me permission to share his thoughts with you. Here they are:

“In the old days of the gold standard, governments used to be able to pump more money into the economy by buying gold for paper money. If there was too much money, then a government could sell gold bullion and take some of the cash back out of circulation.

“These days, we are not on a gold standard. We are on the ”debt standard.” The Fed uses T-Bonds in lieu of gold to add or subtract ‘cash’ from circulation. And lately, the Fed is on a buying binge known as QE2, which is taking bonds out of the hands of big banks and giving them cash. That cash has to go somewhere, so it works its way into the economy. 

”It gets to the economy by way of the stock market. More cash in the banking system means more liquidity to drive up stock prices. We can see in the chart above that when the Fed has been conducting POMOs, it has generally been a great time for the bulls. And when the Fed turns off the spigot, as it did in April 2010, what follows is illiquidity and the Flash Crash. 

”Ben Bernanke says that he is planning to continue QE2 as scheduled up through June. Interestingly, this period of extra money happens to coincide well with the months of normal seasonal strength, when the stock market tends to go up anyway. And the Fed plans to try to wean the money-junkie banking system off of its POMO addiction just as we will be entering the June to October period of seasonal weakness.

”I do not envision that turning out well. For right now, however, the mission is to make as much off of the uptrend as we can, to better survive the nuclear winter which the Fed’s monkeying around will create. 

”Bottom Line: The Fed is supposed to work in a countercyclical fashion, feeding the market when it needs it, and starving it when it is too strong. Right now, the Fed is feeding extra liquidity during the strong season of the year, which is great at the moment, but which will hurt badly later.”

The green bars at the bottom of the chart show when the POMO has been the most intense and the blank spots are where POMO ceased. The fear among analysts like Tom is that if POMO ends again as it did in April last year, a decline on the order of the May-June 2010 could ensue. 

The hope is that either the market will be a lot stronger and more self-sustaining by the time POMO stops; or that either QE2 will segue into QE3 and QE4; or that the end of QE2 will be more of a taper than a halt — sort of like moving to methadone from heroin before going cold turkey.

In any of these cases, the most important thing to keep in mind is that the Fed is extremely unlikely to raise interest rates this year, and is unlikely to raise them in 2012 either — so long as unemployment remains above 7.5%. With inflation also low, the environment is still right for market gains. So, we have something new to worry about when summer approaches. But for now, to mix metaphors, let’s make hay while the sun shines.

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