If you are angry about LIBOR – angry that 18 banks can set one of the world’s most important interest rates in such a poorly supervised, ill-understood manner – you should 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? Let me explain. Words: 810
So says John Stepek in edited excerpts from his original article* as posted on MoneyWeek.com.
Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!) and www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) has edited the article below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.
Stepek goes on to say, in part:
Research regarding the ‘equity premium puzzle’ reveals that 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. Moreover, it provides official proof of the existence of the ‘Greenspan put’.
The Equity Premium Puzzle
The research, by David Lucca and Emanuel Moench, took a look at the ‘equity premium puzzle’ that people who believe in efficient markets tie themselves in knots about…Efficient market philosophy maintains that 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 and 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.
Stocks’ Free Lunch
Lucca and Moench took a look at the action in stocks since 1994 when the Federal Reserve started announcing its decision on interest rates regularly at 2:15pm on given days, eight times a year….and they found that 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.
The chart of the S&P 500 below shows just how much the Fed has affected stocks since 1994. 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
In case you still can’t quite believe your eyes let me spell it out for you. 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….
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…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’ which 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.
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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 Wealth Effect & Moral Hazard
The fact that the effect is only present in stocks also suggests that it is 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 and there is a reason for this….America’s leaders realise that there’s a ‘wealth effect’ attached to the stock market. When stocks are rising, people feel richer….The trouble is, [though, that] 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.
The Investment Implications
What can you do about this?…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 whether, and if so then when, a third round of quantitative easing 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.
*http://www.moneyweek.com/investments/stock-markets/us/us-federal-reserve-sp500-stock-market-manipulation-22900 (To access the above article please copy the URL and paste it into your browser.)
Editor’s Note: The above article may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.
We are continuing to see ongoing pessimism among individual investors about the short-term direction of stock prices [but if you are a contrarian you should bet on a continued rise in stocks despite the continued sense of unease. Let’s take a look at a few charts that tell the story.] Words: 510
Looking at the charts we…[see] a very strong double-top formation – very similar to what we saw back in 1980….[which suggests] that we are headed all the way back down again, possibly even to the lows that we saw in 2011….This is likely to weigh on equities. Words: 291
Goldman Sachs reports their Global Economic Indicators (GLI) show the world has re-entered a contraction and…is predicting a market crash worse than that of the early 90′s recession and one slightly less than the sell-off at the turn of the millennium. [Below are graphs to support their contentions.] Words: 250
The latest research note from CITI’s Richard Schellbach includes the firm’s “Multi-asset Investment Clock” which tells us we are now at 8 o’clock. What does that mean? Take a look.
As investors become more and more worried about the world economy…it makes sense to us to look into stocks that held up best in periods of market decline. Managing risk is as important as reaching for return. One aspect of managing for risk is the past behavior of particular stocks in negative market periods. Toward that end, we identified four key, recent down periods for the S&P 500, and identified those liquid stocks that were in the top quartile for price return in each of those four periods, and did at least as well as the S&P 500 index in the 2008 crash period. [Take a look!] Words: 620
Marc Faber has stated in an interview* on Bloomberg Television that “I think the market will have difficulties to move up strongly unless we have a massive QE3 (something Faber thinks would “definitely occur” if the S&P 500 dropped another 100 to 150 points. If it bounces back to 1,400, he said, the Fed will probably wait to see how the economy develops)….. If the market makes a new high, it will be with very few stocks pushing up and the majority of stocks having already rolled over….If it moves and makes a high above 1,422, the second half of the year could witness a crash, like in 1987.” Words: 708
Investors are being told that the worsening sovereign debt crisis in Europe will leave the U.S. economy unscathed….[because,] since we don’t make many things to export to Europe, our GDP won’t suffer a significant decline at all…. What [has been] conveniently overlooked, [however’] is the fact that 40% of S&P 500 earnings are derived from foreign economies and the seventeen countries that make up the Eurozone have collapsed into recession. [Let me explain what effect that will have on the performance of the S&P 500 this summer.] Words: 325
At the end of November 2011 the U.S. behavioral indicator for the U.S. stock market, based on insights on investor psychology, touched the crisis threshold for the fifth time (1971,1979, 1986, 2006) since 1970. If the current case follows the four prior cases, we expect a similar positive return from November 2011 to the end of October 2012 as in the four prior periods followed by a decline somewhere between 15% and 30%. [Let me explain.] Words: 317
The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. My latest estimates [suggest] that the broad stock market is about 33% above its arithmetic mean and 42% above its geometric mean……Periods of over- and under-valuation can last for many years at a time, however, so the Q Ratio is not a useful indicator for short-term investment timelines [and, as such,] is more appropriate for formulating expectations for long-term market performance. [Let me review the Q ratio with you, along with several graphs, so you can clearly understand what the Q ratio is, how it works and what it is currently conveying.] Words: 800