The Fed and the Stock Market

On the comments section of just about any news article discussing the stock market’s rise, I see numerous comments arguing that the Fed has created an artificial rise in stock prices since 2009 by flooding the market with fiat money. So, in this article I want to give an argument for why I don’t believe the stock market’s rally is artificial.

First, looking beyond daily or even multi-month swings, the direction of stocks should correspond to the direction of expected corporate earnings. All of the other things we hear about in the news (monetary policy, taxes, government spending, GDP, etc.) affect stocks only to the extent that they affect earnings expectations. The primary cause of falling earnings is a recession. Thus, as long as the economy is not contracting, stocks should rise. Granted, the market often tops/bottoms before the economy tops/bottoms, which is why I find Elliott Wave theory to be valuable.

Some have expressed the concern that, since economic growth has been slower than usual in this recovery, it is not justified for stocks to keep rising; therefore, the market must be artificially manipulated. However, slow growth, in and of itself, should not cause the market to fall given that slow growth is still growth. But because the stock market is forward-looking, when economic growth slows, recession fears surge which can cause market drops of up to 25%. If economic growth slows, and the Fed attempts to boost aggregate demand by sending more money into the financial system that banks could lend out, the stock market resumes its advance because recession fears subside. So, I do not deny that the Fed’s monetary policy indirectly influences stocks. But the Fed influences stocks by adjusting investors’ economic expectations.

If the stock market were artificially inflated, one way that could happen is through general inflation that causes all prices in the economy to increase, and thus stock prices to increase even though demand for stocks isn’t rising. However, the chart of the Dow, adjusted for the Consumer Price Index, still shows a very strong bull market since 2009:

Macrotrends.org_Dow_Jones_100_Year_Historical_Chart
Source: http://www.macrotrends.net

On the chart above, notice what happened during 1966-1982, when we really did have an inflation problem. The inflation-adjusted Dow fell 73% even though the nominal Dow went sideways!

Some have said that the Fed’s loose monetary policy results in low returns on all interest-paying investments, so investors automatically put all their money in the stock market since that’s the only place where you get high returns. I acknowledge that this effect has probably strengthened the stock market’s rise. However, this effect can only happen if stocks are expected to rise based on fundamentals. If investors think stocks are overvalued, or think earnings will fall, and thus expect stock prices to fall, they would rather invest in bonds and get a small but positive return than to invest in stocks and get a negative return. So, even if low interest rates are a tailwind for stocks, there still has to be a fundamental backing.

Perhaps the Fed’s biggest contribution to the bull market has been through making many investors skeptical of the market, and thus preventing a massive bullish crowd from forming that would herald a long-term top.

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