A recurring theme in the financial media in the past few years is the increasing influence of central banks in propping up stocks. An intriguing paper out this week from James Montier and Philip Pilkington of investment management group GMO attempts to quantify to what extent the US stockmarket is a “monetary policy junkie” getting a high from the central bank.
The authors built on research done by the Fed itself, which determined that a hefty proportion of annual returns came on days when the Fed’s monetary policy committee (FOMC) was meeting. They compared the S&P 500’s long-term progress from the mid-1960s with its performance excluding FOMC meeting days.
For the past 30 years or so, “these announcement days have had a major, and increasing, impact” on stocks. During the quantitative easing era, returns were substantially higher. In sum, “FOMC days account for 25% of the total real returns we have witnessed since 1984”. Interestingly, it made little difference to the daily returns whether the Fed was actually cutting rates or raising them.
The fact that it was meeting appears to have been enough to boost investors’ animal spirits. The bottom line, though, is that the Fed has artificially inflated valuations over the past two decades. To gauge just how much, Montier and Pilkington looked at the S&P’s cyclically adjusted price/earnings ratio (Cape) on the one hand, and the Cape minus the influence on valuations of the FOMC days – a “monetary policy-adjusted Cape”.
There is currently a gap of around eight between the actual Cape and the Cape minus FOMC days.“If we remove the impact of the FOMC days, the Cape looks to be significantly more mean-reverting than it has been over the past 20 years,” say the authors. It would have peaked at a lower level in 2000 and bottomed at single digits (rather than around 11) in 2009 – “levels of valuation associated with a serious crisis”. In short, the Fed prevented valuations from hitting bargain-basement levels, which would have implied healthier long-term returns.