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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.
Take Note:
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.
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