This Libor thing has really annoyed people.
Yet anyone who cared to look knew that Libor was a wobbly benchmark. The methodology – 18 or so banks pull numbers out of thin air then knock off the top and bottom estimates – has never been secret. Worries about Libor fixing have been a regular feature of the back pages of the FT for several years now.
Of course, the blatancy of the rigging, and the arrogance of the banks, has been a big factor in the public outcry.
But what’s really happening now is that the general public is getting a look under the bonnet of the financial system. And they’ve discovered that the engine of the sleek-bodied sportscar that delivered them the illusion of wealth in the good times, is in fact a mass of loose screws and unsheathed wiring held together with sticky tape and false promises.
I suspect that Libor is just the tip of the iceberg.
For example: what if I told you that the vast majority of gains seen in the stock market over the last 18 years were all down to the actions of a single bank?
The secret driving force behind the stock market’s gains since 1994
A piece of quite staggering research came out from the Federal Reserve Bank of New York last week. It hasn’t received quite the attention it deserves over here yet. But then, nor did the Libor scandal when it first broke.
David Lucca and Emanuel Moench took a look at the ‘equity premium puzzle’. This is one of those theoretical things that people who believe in efficient markets tie themselves in knots about.
In short, the long-term return you get on an asset class should reflect how risky it is. After all, why would you buy a very risky asset if it only returned the same on average as a slightly risky asset?
So, given a free market comprising rational economic actors, the higher the risk involved in an asset, the higher the return should be.
The ‘equity premium puzzle’ refers to the fact that the average return on stocks is actually larger than you’d expect, given their riskiness. In other words, you’re getting a bit of a free lunch by investing in stocks. That’s not supposed to happen.
Anyway, Lucca and Moench took a look at the action in stocks since 1994. That’s when the Federal Reserve started announcing its decision on interest rates regularly at 2:15pm on given days, eight times a year. (Similarly to the way the Bank of England does it, only our mob do it once a month).
Here’s what they found. Stocks moved significantly higher in the 24 hours before the Fed’s announcement.
How significantly? Very.
Say Lucca and Moench, “more than 80% of the annual equity premium has been earned over the 24 hours preceding scheduled” Fed announcements.
That sounds a bit jargon-y. So thankfully, the pair have included a chart of the S&P 500 that shows just how much the Fed has affected stocks since 1994. Take a look at it below.
The blue line shows the S&P 500 index. The red line shows the S&P 500 with each 24-hour ‘pre-Fed meeting’ period excluded.
S&P 500 index with & without 24-hour pre-FOMC returns
I’ll just spell it out, in case you still can’t quite believe your eyes. If it wasn’t for the Fed, then the S&P 500 would today be struggling to hold the 600 mark, rather than wrestling with 1,300.
Interestingly, the Fed’s decisions also have an impact on international stocks, including our own FTSE 100. In fact, the Fed has more impact on the FTSE 100 than the Bank of England does, if Lucca and Moench’s research is right.
Proof of the Greenspan put
The effect is restricted to Fed decisions – other macro-economic data don’t create the same sort of moves. Also, the impact is only felt in stocks, not commodities or currency markets.
Now, I’m sure there are a lot of ways to interpret this data (although Lucca and Moench are at a loss as to how to explain it). I’m sure various papers defending the prejudices of the economic establishment are being written even as I type.
But to me the explanation is pretty obvious. As one commenter on Lucca and Moench’s post puts it, this is official proof of the existence of the ‘Greenspan put’.
‘The Greenspan put’ refers to the notion that former Fed chief Alan Greenspan would always cut interest rates if it looked as though Wall Street was going to suffer too much pain. His successor, Ben Bernanke, has a similar tendency.
The market moves come before the Fed makes its decision, not after. But all that demonstrates is the huge faith that investors have in the Fed’s ability and desire to prop the market up. And the reason they have that faith, is presumably because the Fed always loosens when the market looks to be in trouble.
The fact that the effect is only present in stocks also suggests that it’s stock markets that are uppermost in the Fed’s mind. This makes sense. Bernanke even admitted that one of the key aims of the second batch of quantitative easing was to boost the stock market.
There’s a reason for this. Just as the authorities in Britain understand that rising house prices are the key to the ‘feel-good’ factor (which is why the Bank of England props them up), so America’s leaders realise that there’s a ‘wealth effect’ attached to the stock market. When stocks are rising, people feel richer. So you can see why Bernanke wants to ramp them.
The trouble is, it also creates rampant moral hazard. People take bigger risks than they should. They borrow money to fund projects that don’t justify it. The whole economy becomes distorted in order to keep one ‘special’ market rising.
So let’s say you’re angry about Libor – you’re angry that 18 banks can set one of the world’s most important interest rates in such a poorly supervised, ill-understood manner.
Well, shouldn’t you be even angrier that just 12 people sitting in a room can set the world’s single most important interest rate to suit the needs of the stock market, all under the pretence of controlling inflation?
The investment implications
What can you do about this? I suspect there’s a hedge fund somewhere already setting up to take advantage of this apparent market anomaly. And you could always get a calendar of Fed announcements out and bet accordingly.
But I think the main thing to take away from all this is that if you’re wondering when and whether a third round of quantitative easing (QE3) is coming, you need to watch the S&P 500. After all, that’s clearly what the Fed is watching.
In the meantime, as long as QE remains on the back burner, we can probably expect markets to keep moving sideways and remain vulnerable to nasty surprises. So it’s more important than ever to get a decent income from your investments while you wait for better days – we’ll be looking at how to do so in the next issue of MoneyWeek magazine, out on Friday (If you would like to become a subscriber you can subscribe to MoneyWeek magazine).
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