The Stock Market As Monetary Policy Junkie by Evergreen Gavekal
CHAIRMAN WAXMAN: “You found a flaw?”
MR. GREENSPAN: “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.”
CHAIRMAN WAXMAN: “In other words, you found that your view of the world, your ideology, was not right, it was not working.”
MR. GREENSPAN: “Precisely. That’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”
– Congressional Hearing on The Financial Crisis and the Role of Federal Regulators. October 23, 2008, as relayed by Mike O’Rourke on March 30th, 2016, in The Closing Print.
From the Evergreen Investment Team:
- This month’s Guest EVA is based on a recent essay by GMO, a Boston-based investment advisory firm with $118 billion in assets under management. It was written by James Montier and Philip Pilkington who seek to understand why the US stock market has persistently traded at higher valuation levels over the last twenty years than in the prior century. (Note, GMO was co-founded by Jeremy Grantham, so often quoted in past EVAs.)
- Contrary to what some market pundits believe, James and Philip found that the unusually elevated price/earnings ratios since 1995 are not related to low interest rates. Rather, they appear to be linked to a market increasingly influenced by Federal Reserve Open Market Committee (FOMC) meetings. Intriguingly, the higher returns seen around the time of these meetings aren’t limited to just those events when the Fed eases monetary policy or elects to stand pat.
- They have deconstructed the famous “Shiller P/E” (also known as the “Cyclically-Adjusted P/E”), attempting to isolate what factors have caused its forecast error. Essentially, the authors believe the Fed has been able to positively influence investors’ willingness to assume risk. In other words, the US central bank has successfully stoked the animal spirits of market participants. (Quite possibly by creating a belief that the Fed is all-knowing and all-powerful. The exchange quoted above, between Alan Greenspan and Congressman Henry Waxman, should challenge that mindset.)
- Ironically, one of the Fed’s own studies revealed that market returns on FOMC meeting dates have been considerably higher than during the overwhelming majority of trading sessions when it was not convened. Since 1985, there have been an average of only eight FOMC meeting days per year (thus, roughly 3% of trading sessions) yet these have accounted for 25% of the market’s total return!
- The correlation between Fed meetings and market returns hit its peak during the Global Financial Crisis (GFC) and its immediate aftermath. However, it continues to run far above its pre-early ‘80s level.
- By adjusting the Shiller P/E to account for this effect, its indications of under- or over-valuation have been much more accurate.
- The so-called “Fed-put” is the notion that the US central bank has repeatedly intervened to halt bear markets. This started under Alan Greenspan when he assumed the chairmanship in 1987 and has, according to this notion, continued under Ben Bernanke and Janet Yellen.
- A profound question is whether this is a permanent condition or one that will give way to an era of far more skeptical investor attitudes, characterized by a lack of faith in the Fed’s ability to influence market direction.
The Stock Market As Monetary Policy Junkie: Quantifying The Fed’s Impact On The S&P 500
By James Montier, Philip Pilkington
Introduction. Jeremy Grantham has a lovely saying that resonates deeply with us, and it is, “Always cry over spilt milk.” Analyzing past errors and mistakes is crucial to improving our understanding, and vital if we are to stand any chance of avoiding making similar errors in the future. Indeed, “Always Cry Over Spilt Milk” was the title of an internal investment conference we held at GMO towards the end of last year. The deeper subject was seeking to understand why our forecast for the S&P 500 had been too pessimistic over the last two decades or so.
In August 2015, we shared some of the work that emerged from that event in the white paper, “The Idolatry of Interest Rates, Part II.” We would like to highlight two elements from that work that are of particular relevance for this note. First, we showed that our basic valuation framework has tended to underestimate the returns to the U.S. market of late because the market has simply turned out to be more expensive than we had expected (see Exhibit 1). Second, we showed that despite many protestations to the contrary, low interest rates didn’t really seem to be a viable explanation for the market’s high P/E.
This, of course, raises the question as to what might account for the higher P/E if it isn’t interest rates. At the end of one of our recent pieces* we speculated that the Fed might well have a role to play in a broader sense than simply its interest rate decisions. We cited the late, great Nicholas Kaldor from a paper he wrote in 1958 arguing:
Reliance on monetary policy as an effective stabilising device would involve…a high degree of instability…in the capital market…The capital market would become far more speculative…longer run considerations of … profitability would play a subordinate role. As Keynes said, when the capital investment of a country “becomes the by-product of the activities of a casino, the job is likely to be ill-done.”
Effectively, the Fed created enormous “moral hazard” and investors have been force-fed risk assets. (Hence we have occasionally referred to this as a foie gras market.) Whilst this seemed preeminently plausible to us, we didn’t have any evidence to offer until recently.
From the belly of the beast. In a delicious stroke of irony, the idea for our approach actually stemmed from research originating at the Fed! In 2013, two economists at the New York Federal Reserve published a paper entitled “The Pre- FOMC Announcement Drift.” In this paper the economists document “large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the FOMC in the past few decades” (Lucca & Moench, 2013).
In a nutshell, the authors found that significant amounts of annual stock market returns over the past 30 years were made on FOMC meeting days. What is more, the authors found that “these pre-FOMC returns have increased over time and account for sizeable fractions of total annual realized stock returns.”
The New York Fed economists utilized tick data from the stock market to aid in their explorations. They were interested in determining whether these divergences could be explained by actual new information passed on to the market after the FOMC had made its decisions or whether they were due to simple anticipation by the markets of the FOMC decisions. They concluded that the returns could not be explained by markets “pricing in” FOMC decisions.
We were less interested in this particular aspect, but the approach sparked an idea in relation to what we might call the Kaldor hypothesis, which is essentially that the Fed has had a meaningful impact on market behaviour. Rather than using tick data as the Fed researchers did, we used full-day data, but reached a very