When Market Returns Are Reliant On a Single Word
The S&P 500 stock market index reached an all-time high in May, at more than three times its post-crisis trough of six years ago.
Many credit the Fed's quantitative easing and swapping of short- for long-term Treasuries for fostering these bumper investment returns. Yet the market volatility surrounding recent Fed pronouncements ought to give investors pause. When so much rides on a single word like "patient," something must be amiss. Has the Fed really restored the economy's health, or are we living in a fool's paradise? For me, an investment professional with a fiduciary duty, this is more than an academic or political concern.
Investors' returns reflect two factors. One is the internal return generated by the underlying asset. The Fed's actions haven't increased that return much, if at all: return on equity for the S&P 500 is only slightly higher now, at 14%, than its twenty-five year average, 13%. The second factor is the multiple of the asset's earnings power that buyers are prepared to pay when they purchase it-the price to earnings (P/E) multiple. This is what monetary manipulation has affected: buyers today are willing to pay more for the same underlying return on equity than they were a few years ago.
Former Fed chairman Ben Bernanke has attributed this phenomenon to something called the "portfolio balance channel." When the Fed purchases Treasuries, it reduces the supply available to investors. With fewer treasuries on the market, some investors bid up their prices, lowering their yields. Other investors, who need higher yields, buy corporate bonds to replace their Treasury holdings. This pattern repeats itself-prices rise, yields fall, and investors looking for a return pile into another, riskier asset class-all the way through the spectrum of securities. As investors change the balance of their portfolios, asset values are driven up, and everyone appears to be getting richer-even though the underlying earnings power of their assets remains the same.
Imagine an investor with $10,000 in a money market fund. Prior to current Fed policy, that $10,000 might have earned 3% interest. The investor could buy 100 shares of her favorite stock for $100 each with a 5% dividend yield, but she likes the safety of the money market and 3% interest satisfies her income need. Then the Fed forces interest rates to zero. Requiring some income, this investor feels compelled to buy the stock, only now it trades at $250 to yield 2%-the portfolio balance channel at work.
The seller of the stock appears richer, but his wealth has merely been "pulled forward" from the future, as he now earns zero on his proceeds. The buyer of the stock, meanwhile, faces greater risk for a lower return-she is worse off than she was to begin with. Remember, the underlying earnings power of the business experiences absolutely no change, but its perceived value still goes up and every similar business is "marked to market" at a higher rate. The spiral continues.
This is hardly uncharted territory. From 1945 until the turn of the century, the average P/E multiple for the S&P 500 index was 15. In 1999, the P/E multiple peaked at over 30. This multiple proved so high that stock market returns have been meager since: from 2000 through 2014, the S&P 500 provided an annual return of just 4.2%, compared to a long-run average of close to 10%. In hindsight, it is clear that high stock market returns during the second half of the 1990s were not rooted in a sustainable improvement in underlying business fundamentals. Instead, those returns robbed from the fourteen years that followed.
The Fed's actions over the past six years may have created a similar dynamic. Lured to speculate by the Fed's manipulation, investors have again driven multiples to high levels. At the close of the first quarter, the S&P 500 P/E multiple was 20-less than in 1999, but also a third higher than the historical average. At best, this has "pulled forward" returns, and investors should prepare for another decade of low returns. At worst, investors will soon suffer the third significant stock market correction of the 21st century.
Should serious market turmoil surface, investors will be willing to hold cash no matter how low the return is. The "portfolio balance channel" will break down and investment multiples on riskier assets will revert to their historical average (or below) at a rapid pace. That's what happened in 2001 and again in 2008: the stock market lost half its value, despite Fed efforts to impede the fall.
Ever since the financial crisis, the Fed has tried to restore prosperity by re-inflating asset prices. Asset prices have risen alright, but recovery has been lackluster. And those high asset prices are themselves nothing to celebrate. Stock prices are higher, but long-term returns haven't improved. Ultimately, the Fed's actions may just have set the stage for the next market crash-and if boom does turn to bust, we're in for a rough ride. Perhaps it's time to consider ending the Fed's manipulations for good.
