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Is the Fed Responsible for 800% Gains in the Stock Market?

In a recent post I shared how the US stock market is now up over 800% since the financial crisis.

At the right time, my Twitter replies and inbox were full of people saddened by the fact that this entire bull market was an artifact of the Federal Reserve’s policies.

Yes, what do you expect if you print trillions of dollars?

Fixed stocks are up, but only because the Fed removed price discovery.

It’s all a house of cards.

I know I shouldn’t be surprised by these comments because they’ve been around for over a decade but it’s amazing how many investors really Hate the Fed.

A lot of this has to do with the fact that many people have been wrong about the direction of the market since the bull market began, but it would be hard to ignore how the Fed is engaged with the financial markets.

The Fed’s balance sheet has grown to epic proportions since the 2008 financial crisis:

A little less than $1 trillion in early 2008, the Fed now has about $9 trillion on its balance sheet.

Now look at a simple chart of the S&P 500 with the Fed’s balance sheet:

They are both too much. The case is closed isn’t it?

But what about Japan and Europe? Their central banks have also taken trillions of dollars in assets on their balance sheets.

Here’s the Bank of Japan balance sheet compared to MSCI Japan (the number is in yen so it’s actually more like $6-7 trillion):

And here are the assets of the European Central Bank with respect to MSCI Europe:

I mean look at all these charts. There are two lines going in the same direction.

So what if the scales are off, it’s clear proof that the central bank is the only reason stocks are high, right?

At first glance it seems to be an open and closed affair but it is not always that simple.

Just because two lines on a chart are going in the same direction, doesn’t mean that correlation means causation. case in point:

OK, this is ridiculous but you get the idea. It’s not that hard to show two datasets going in the same direction.

And while returns for stocks in the US, Japan, and Europe have risen over the past 10 years, they haven’t been above nearly the same magnitude:

The S&P 500 has outperformed stocks in each of these developed countries by more than 200% overall over the past decade. These countries are providing a similar level of monetary stimulus during this time and their interest rates have been lower than ours.

While the 10-year US Treasury bond yield currently stands at around 1.7%, the yield in Japan (0.1%) and Germany (-0.1%) is much lower. Why aren’t stocks bursting higher in those countries?

Interest rates certainly have an effect on how people allocate their capital but low interest rates alone do not explain everything that happens in the financial markets. Take a look at Japan’s 10-year government bond yields at the turn of the century:

It has remained less than 2% for the entire 21st century. That means Japan must have a huge stock market bubble, right?

In contrast, the MSCI Japan Index is up just 2% per year since 2000, and that number includes dividend reinvestment. Stocks have basically gone nowhere despite consistently low rates.

And think about where interest rates were in the United States during the last true stock market frenzy in the dot-com bubble of the late 1990s.

From 1995–1999, when the Nasdaq total was up 450% (41% per year), 10-year Treasuries yielded an average of over 6%. Interest rates have no effect on human behavior when it comes to sending the markets into frenzy.

Obviously, it would be ridiculous to say that the Fed has had no effect on the markets since 2008. Without the intervention of the Fed, the financial system could explode in 2008 and 2020.

Take a look at the fall in corporate bonds in March 2020 and the subsequent recovery:

Corporate bonds were down 22% in two weeks. He basically round-tripped that entire loss three weeks later. This does not happen if the Fed does not give its implied support to the bond market.

This makes sense when you consider that the Fed is basically the lender of last resort for the financial system. They don’t want to see a run on the banks or a repeat of the Great Depression and they have the tools to make sure that doesn’t happen.

The Fed likely has a psychological grip on the markets now that they are such a big player in the bond market.

I’m not going to argue with you if you claim that the Fed talks about buying mortgage bonds and treasuries with the recovery seen in stocks, GDP, housing, bonds and unemployment rates, their welcome is over. (not to mention increased inflation).

Consumer balance sheets have never been stronger than they are today:

If the Fed isn’t going to apply the brakes now, when will they?

If we can’t handle 4 or 5 rate hikes in this environment, the Fed can even tell us they’ll never raise rates again.

So while the Fed has been a big player in the markets since 2008, it would be foolish to assume that this is the only reason for the stock’s upward move.

Interest rates and bond purchases alone are not enough to fuel the stock market bubble. Human nature can do this all by itself.

Michael and I spoke on this week’s Animal Spirits about the puzzles we find in the feds themselves and more:


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Further reading:
Emotions matter more than interest rates

Now here’s what I’ve been reading lately:

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