Wednesday, May 7, 2014

So how can the Fed hold back the economy and goose stock prices at the same time?

Allan Meltzer, in today's Wall Street Journal, like so many others, credits the Fed for this remarkable bull run in stocks:
Ironically, despite often repeated demands for increased redistribution to favor middle- and lower-income groups, the policies pursued by the Obama administration and supported by the Federal Reserve have accomplished the opposite. When the president campaigns in the midterm election, he will talk about the relative gains by the 1%. Voters should recognize that goosing the stock market through very low interest rates, not to mention the subsidies and handouts to cronies, have contributed to that result.

Earlier in his column he writes:
The Fed's unprecedented quantitative easing since 2008 failed to lead to a robust recovery. The unemployment rate has gradually declined, but the main reason is that workers have withdrawn from the labor force. The stock market boomed, bringing support from traders, but the rise in asset prices of equities didn't stimulate growth by inducing investment in new capital. Investment continues to be sluggish.

Now, I'm all in with Meltzer in terms of the ill-conceived policies of today's powers that be. But, frankly, I struggle with the tired line about the stock market gains being all about Fed "goosing".

Think about it: As Meltzer rightly states, "the Fed's unprecedented quantitative easing since 2008 failed to lead to a robust recovery." Far from it in fact. Yet, the stock market "boomed". The notion that the stock market would in fact "boom", or, I should say, continue to "boom" (as it can certainly "boom" in anticipation of a robust recovery), amid a most tepid economic recovery, frankly, makes no sense. The it's-all-about-the-Fed crowd never seem to mention record corporate earnings when they talk about record quantitative easing. I don't suppose, therefore, that they're crediting---at least not entirely---quantitative easing for record corporate profits.

So when Electronic Arts reports blowout earnings (yesterday) and the stock price jumps 14% in the after market, does the it's-all-about-the-Fed crowd stand up and say "see, QE is goosing stock prices"? I certainly hope not. Or when Amazon's stock plunges 10% (last Friday) on disappointing numbers, or Ford's is down 3%+ (last Friday) for its uninspiring performance, well, what about them apples? I mean if it's all about the Fed, earnings disappointments should be brushed off amid Yellen's promise to keep rates low way into the foreseeable future. Oh, and speaking of apples, Apple blew away top and bottom line estimates and its stock price rewarded shareholders handsomely as a result. Was that all about the Fed?

Regular readers know that I largely share Meltzer's view that the Fed, in its efforts to be the be all and end all for the economy, is playing a very dangerous game. And I'm warming up to the idea that while "accommodation" is the Fed's description of present policy, tighter regulations, along with the interest it now pays banks on their excess reserves, is anything but accommodative. Meaning, Fed actions may after all be, in fact, holding the economy back. But if that's the case, you'd almost have to conclude that the Fed is holding back the stock market as well (could the market be even higher were it not for the Fed?). Which is opposite the case being made by many of the folks, like Meltzer, who believe the Fed is holding back the economy. Hmm...

Lastly, just to get in front of an email or two from anyone who would point to my seeming naiveté, I'll, in bullet point fashion, answer the question I ask in the title:

How can the Fed goose stock prices?

  • By killing the stock market's competition by keeping interest rates extremely low.

  • By boosting corporate profits by lowering borrowing costs.

  • Conventional wisdom says P/Es should be higher when interest rates are lower. Therefore, keeping interest rates very low permits very high stock prices.

  • Investors who believe that the Fed will ultimately succeed in boosting the economy will bid stocks higher in anticipation---during this period of "accommodation".

I'm sure if I think harder I could add another one or two, but it's getting late.

Aside from the second point---which by itself is insufficient---none of the above explain how the Fed might be boosting corporate earnings (well, I guess you could argue the fourth point, should they succeed, as well). And, at the end of the day, when the price of your average share of stock trades at a multiple above earnings that is consistent with the long-term average, the it's-all-about-the-Fed argument---in that it can't explain record earnings---loses its steam. Otherwise stocks, in the aggregate, would be trading at multiples that would have folks exiting the market like it's 1999.  

Now, all that said, it would not surprise me in the least to see the stock market contract when the Fed finally embarks on its quest to rein in what it's done over the past few years. Which simply means that while the Fed, in my view, does not deserve the credit for this bull market, it could very well earn some of the blame for ultimately ending it...

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