The Stock Market Is A Monetary Policy Junkie – Quantifying The Fed’s Unprecedented Impact On The S&P
By Tyler Durden
This, of course, raises the question as to what might account for the higher P/E if it isn’t interest rates. At the end of one of our recent pieces1 we speculated that the Fed might well have a role to play in a broader sense than simply its interest rate decisions. We cited the late, great Nicholas Kaldor from a paper he wrote in 1958 arguing:
Reliance on monetary policy as an effective stabilizing device would involve…a high degree of instability…in the capital market…The capital market would become far more speculative… longer run considerations of… profitability would play a subordinate role. As Keynes said, when the capital investment of a country “becomes the by-product of the activities of a casino, the job is likely to be ill-done.”
Effectively, the Fed created enormous “moral hazard” and investors have been force-fed risk assets. (Hence we have occasionally referred to this as a foie gras market.) Whilst this seemed preeminently plausible to us, we didn’t have any evidence to offer until recently.
From the belly of the beast
In a delicious stroke of irony, the idea for our approach actually stemmed from research originating at the Fed! In 2013, two economists at the New York Federal Reserve published a paper entitled “The Pre-FOMC Announcement Drift.” In this paper the economists document “large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the FOMC in the past few decades” (Lucca & Moench, 2013).
In a nutshell, the authors found that significant amounts of annual stock market returns over the past 30 years were made on FOMC meeting days. What is more, the authors found that “these pre-FOMC returns have increased over time and account for sizeable fractions of total annual realized stock returns.”
The New York Fed economists utilized tick data from the stock market to aid in their explorations. They were interested in determining whether these divergences could be explained by actual new information passed on to the market after the FOMC had made its decisions or whether they were due to simple anticipation by the markets of the FOMC decisions. They concluded that the returns could not be explained by markets “pricing in” FOMC decisions.
We were less interested in this particular aspect, but the approach sparked an idea in relation to what we might call the Kaldor hypothesis, which is essentially that the Fed has had a meaningful impact on market behaviour. Rather than using tick data as the Fed researchers did, we used full-day data, but reached a very similar conclusion.
Exhibit 2 plots the S&P 500 together with an adjusted series, which shows the impact of removing the days when the FOMC was meeting. Exhibit 3 plots the same data in relative cumulative space (effectively a strategy of going long the market on days when the FOMC was meeting, and zero all the other days of the year). A cursory glance at either chart shows that sometime around 1985 …read more
Source: The Stock Market Is A Monetary Policy Junkie – Quantifying The Fed’s Unprecedented Impact On The S&P
