- The commonly-held view that Fed policy has been the main driver of the recent rally and will prevent future losses reflects ex-post justification rather than critical analysis of the data.
- While all else equal, lower rates raise the present value of future cash flows, all else is rarely equal as low rates tend to both reflect and result in weak growth.
- In reality, monetary policy is just one of countless market drivers, explaining why there is no evidence from the data to support its perceived importance.
- Blind faith in the Fed’s omnipotence highlights the desire among investors for simple explanations to complex problems as well as the hope that an inevitable crash can be avoided.
- When we look back through history at the kind of conditions that have prevailed at major market peaks: extreme valuations, feverish speculative sentiment, deteriorating economic fundamentals, and waning market breadth, this one looks like a textbook example highlighting the worst of the worst.
The commonly-held view that Fed policy has been the main driver of the recent rally and will prevent future losses reflects, to a large extent, ex-post justification rather than a critical analysis of the data. In reality, monetary policy is just one of countless market drivers, explaining why there is no evidence from the data to support its perceived importance.
We first wrote about how monetary and fiscal policy would not be able to prevent a market crash back in February (see ‘Monetary And Fiscal Stimulus Will Not Prevent A Market Crash‘) and also explained how low rates do not justify high equity valuations in May (see ‘SP500: Low Bond Yields Do Not Justify High Equity Valuations‘). With markets once again at new all-time highs and faith in the Fed’s ability to prevent another crash widespread, it is worth putting an even finer point on the issue.
Understanding The Theory
The theory behind the role of monetary policy in driving stocks is straightforward; all else equal, the lower the level of interest rates and bond yields, the higher the present value of any given future cash flows. The problem is that all else is rarely equal. Periods of easy monetary policy tend to reflect periods of weak economic growth. Furthermore, as we argued in ‘Brace For Sub-1% Long-Term Growth‘, easy monetary policy also tends to undermine growth by dragging down productivity. The following chart shows how changes in real bond yields tend to lead changes in real GDP growth.
Source: BEA, Robert Shiller, Author’s calculations
When interest rates are set far lower than would have been the case had they reflected the real balance of savings and investment in the economy, it gives entrepreneurs false signals about the availability of resources in the economy, and thus, the future profitability of their investments. During this time, the investment goods production does not align with the end demand from consumers and economic stagnation ultimately results. Low real interest rates tend to manifest in the survival of companies that would otherwise be forced into bankruptcy, enabling labour and capital to move to more productive areas of the economy. They effectively lower the bar for productivity growth, keeping zombie companies alive.
As we explain below, more often than not, such periods of ultra-loose monetary policy have tended to occur alongside depressed equity valuations as concerns over future growth outweigh the impact of the lower discount rate.
Faith In Monetary Policy Reflects Ex-Post Justification
We recognize that the rally in the SPX from the March 23 low has occurred alongside the extraordinary expansion in the Fed’s balance sheet and gone hand in hand with declining real interest rates as measured by U.S. inflation-linked bond yields. However, if monetary policy has been such a key driver of the rally, it is important to ask why this has only become clear in hindsight. In the weeks following the Fed’s extraordinary easing measures that took place at the March trough, the majority of investors believed that such measures would not result in rising equity valuations as evidenced by the high degree of investor bearishness that prevailed on multiple measures at the time.
The same investors who are now convinced that monetary easing has driven (and will continue to drive) the rally are the same investors who were convinced that it would not do so at the time. As GMO’s James Montier recently articulated, this commonly-held belief that monetary policy has driven the rally reflects an ex-post justification rather than the result of a critical analysis of the evidence.
Key Questions Regarding The Importance Of Fed Policy In Driving Stocks
Perhaps the best way to explain why monetary policy has not been the main driver of the recent rally and is generally not a particularly important driver of equity markets is to ask a series of questions:
Why did the early-March aggressive cuts not prevent a market crash?
The 33% decline in the SPX from the February 19 peak to the March 23 low occurred alongside a major dovish shift in monetary policy. Both nominal and real bond yields fell sharply at end of February, and the Fed cut rates aggressively on March 3 by 50bps and again by 100bps on March 15.
Fed Funds Rate Vs SPX
Of course, it could be argued that the fundamental deterioration in the economy resulting from the spread of the coronavirus overwhelmed the otherwise bullish impact of the monetary easing. However, just as the prevailing wisdom at the March low was that monetary policy would not trigger a rally, the prevailing wisdom in the initial stages of the February crash was that the rate cuts actually signaled the Fed’s panic which helped put downside pressure on stocks.
Why has the Fed’s balance sheet reduction since June not undermined the rally?
The size of the Fed’s balance sheet peaked in mid-June, and despite the contraction since then, the SPX has continued to rally to new all-time highs. The Fed’s balance is back to levels initially seen in mid-May, at which point the SPX was trading 30% below current levels. If monetary policy is responsible for driving up stocks in the face of weak economic fundamentals, it seems rather strange that the SPX has powered to new highs in the face of quantitative tightening.
Fed Balance Sheet Vs SPX
Why did the tightening cycle of 2016-2018 occur alongside a major rally?
The rally in the SPX between 2016 and 2018 moved in lockstep with the Fed’s tightening cycle which saw real 10-year bond yields rise over 100bps and the Fed’s balance sheet contract. One could argue that the economy’s fundamental improvement overwhelmed this tightening cycle, but even so, this highlights how monetary policy is not such an important driver of equity market moves.
U.S. Inflation-Linked Bond Yields, Fed Balance Sheet, and SPX
Why are valuations double the level they were the last time real yields were at current levels?
The current deeply negative real interest rate picture is similar to that which prevailed in 2013 when the Fed kept interest rates depressed despite a rise in inflation expectations. 5-year inflation-linked bond yields were actually even lower back then, yet the SPX PE ratio was trading around a half of current levels.
SPX PE Ratio Vs Inflation-Linked Bond Yields
Why have real bond yields and equity valuations been positively correlated over the past two decades?
U.S. 10-year inflation-linked bond yields have been positively correlated with the SPX’s price-to-earnings ratio over the past two decades. The r-squared has been 0.42 over this period and 0.47 when the most recent 5-month period is stripped out.
SPX PE Ratio Vs 10-Year Inflation-Linked Bond Yields
Furthermore, as the chart below shows, the rolling six-month correlation between the SPX’s PE ratio and U.S. real yields has also been positive far more often than it has been negative.
SPX PE Ratio, 10-Year Inflation-Linked Bond Yields, and Rolling Correlation
Why do European stocks trade at much cheaper valuations despite much looser monetary policy? If monetary policy is such a key driver of equity markets, we should see European stocks trade at significantly higher valuations, given that monetary policy is even more loose there than it is in the U.S. In the U.K. For example, real 10-year bond yields are almost 2% lower in than in the U.S. yet most valuation metrics show U.K. stocks trade at a major discount to their U.S. and global counterparts. It could be argued that the fundamental outlook for U.K. stocks is just so much more negative that it outweighs the impact of the easier monetary policy. However, again this suggests that easy monetary policy is clearly not a major driver of equities.
US Vs UK Forward PE Ratios And Inflation-Linked Bond Yields
Why have the most negative real interest rate periods in history occurred alongside some of the cheapest market valuations?
If we go back and look at the long-term history of monetary policy and equity valuations, we can see that the periods when real interest rates have been most negative have occurred alongside periods when equity valuations have been among the cheapest. One particularly important episode was in the 1940s when the Fed agreed to peg the Treasury-bill yield at 0.375 percent and the 10-year government bond yield at 2.5 percent to keep borrowing costs down to pay for the war. As debt issuance rose throughout the war, inflation pressures mounted to the point that real 10-year yields fell to as low as -17% at their trough in March 1947. Despite these extremely negative real yields, both the trailing PE ratio and the CAPE ratio were around 11x, less than half of the levels we see today.
Real 10-Year Yields Vs CAPE Ratio
Why have the largest gaps between the real economy and monetary policy occurred alongside some of the cheapest market valuations?
It could be argued that real interest rates are not the best way to gauge the ease of monetary policy. As we noted above, real interest rates tend to reflect rates of real GDP growth. We can therefore look at periods where real interest rates have been particularly low relative to real GDP growth as an indication that monetary policy is loose relative to the state of the real economy. As the chart below shows, the periods with the easiest monetary policy on this metric have been associated with extremely depressed equity valuations. The most striking example can be seen in early 1951 when real 10-year bond yields were at -7%, while real GDP growth was running at 13%. Despite this staggeringly loose monetary policy stance, the trailing PE ratio was around 8x, while the CAPE ratio was around 12x.
Spread of Real 10-Year Yields Over Real GDP Vs CAPE Ratio
Source: BEA, Robert Shiller, Author’s calculations
The Reality Is Much More Complex Than Most Investors Realize
Given the complete lack of evidence for easy monetary policy supporting stocks, the persistence of such strongly held beliefs around its importance highlights the desire of investors for simple explanations to complex problems. Combine this with the fact that most investors want stocks to rise, and it is easy to see how this financial canard is so widely embraced.
The reality is that stock markets are driven by countless factors that render performance over any given day, weak, or month, or even year random to a large degree. Markets move and then observers make up the reasons afterwards.
Our view is that, while the Fed’s extraordinary easing measures played some role in the market’s rally from the March 23 low, this was marginal at best. After a 33% peak-to-trough decline, the market had become oversold sentiment had become extremely bearish. The Fed’s easing measures reflected the extent of the panic in the market. We had already seen the VIX top out in the preceding week, suggesting that stocks were ready for a relief rally. Short covering provided an additional tailwind, while the strong recovery in tech stocks encouraged retail demand to surge. The more these stocks have rallied, the more investors have been forced to increase their exposure to reduce the risk of dramatically underperforming the market. In turn, this has helped fuel further gains.
Looking To The Future
We are less concerned with finding explanations for past market moves as we are with identifying the market’s forward-looking risk-reward prospects. We recognize that there is seemingly no limit to how extreme valuations can get, and acknowledge that parabolic moves tend to go on longer than expected. However, what we are focused on is the risk-reward profile, and current market conditions share striking similarities with previous periods that have resulted in devastating market losses from both a short and long-term perspective.
The more bubbles advance, the greater the likelihood of positive returns on any given day, but the worse the expected returns become as the risk of major declines grows by the day. When we look back through history at the kind of conditions that have prevailed at major market peaks: extreme valuations, feverish speculative sentiment, deteriorating economic fundamentals, and waning market breadth, this one looks like a textbook example highlighting the worst of the worst.