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PERSPECTIVES: What drives the stock market?

There are no perfect answers but research by Renaissance Investment Group shows the important role played by the Fed.

The age-old question for investors is ‘what are the forces that drive stock markets higher or lower?’. There are no perfect answers, which is why theories abound as numerous as the promises of snake oil salesmen. In this brief article, I will share some of the research carried out by Renaissance Investment Group indicating the important role of the U.S. central bank, the Federal Reserve Bank, in determining the direction of the stock market over the recent past.

Does the Federal Reserve Matter?

Yes, they do.

Our research has shown that between 1945 and 1999, the S&P 500 Index (a broad measure of the U.S. stock market) has risen on average by 2.5 times the rate of economic growth. The measure of the economy we have used is Industrial Production which measure overall industrial activity in the US economy. The only period this proved not to be the case was the decade of the 1970s. This was a period of high inflation and by 1981 interest rates had reached 19% – almost unthinkable today. During this period, the stock market rose in line with the growth in the economy.

Between 2000 and 2007, the stock market rose 2.7 times the growth in the economy which was broadly in line with the previous fifty years. However, since the Financial Crisis that quickly unfolded at the end of 2008, the stock market has risen by 5.5 times the growth in the economy. This has clearly given risen to investors wondering how long the long upward trend in stock prices can continue. But, at the end of 2008, the Federal Reserve Bank started acting in a completely novel way, using policies that had only been tried by one other developed nation, Japan. The Federal Reserve Bank started buying U.S. government bonds and mortgage bonds from domestic banks. In order to pay for these investments, it started printing more dollars, increasing the supply of money in the economy.

In effect, the Federal Reserve Bank, as an arm of the central government, was ‘giving’ money to the private sector. This was in the form of cash to the U.S. Treasury and domestic banks. This cash enabled the government to indulge in ever more expansive policies to promote spending and the domestic banks to repair their finances to help them lend out money. This has been a give away from the government to the entire private sector acting in a similar way as a giant tax cut. By the middle of 2017, the Federal Reserve Bank had amassed around $4.5 trillion of such bond investments, equivalent in size to approximately a quarter of the U.S. economy. And so, the stock market and other risky assets rose in value fairly consistently over this period until……

In 2018, under the incoming new chairman of the Federal Reserve Bank Jerome (Jay) Powell, policy changed. The central bank raised interest rates progressively and started selling some of the bond investments it had built up. In 2018 alone, it sold over $600 billion of these bonds. Now, this action acts rather like a tax increase. It takes money from the private sector, who bought these bonds, and gives it to the government – in this case the Federal Reserve Bank. And so, the stock market fell along with ultra-risky assets such as Bitcoin, which during 2018 lost 82% of its dollar value.

In 2019, however, the Federal Reserve Bank changed its policy once more, cut interest rates dramatically and started buying bonds from the Treasury and banks all over again. Not surprisingly, stock markets and risky assets rose once more……..until the COVID pandemic struck in mid-February 2020. Fearing, correctly, that the economy would enter severe recession, stock prices and very risky assets such as Bitcoin, initially fell sharply. In mid-March 2020, the Federal Reserve Bank, along with most of the central banks of the developed world, went into overdrive. Bond purchases accelerated in a coordinated frenzy of buying and the Federal Reserve Bank increased its holdings of bonds to a current level of $8 trillion with the ‘promise’ of another $3 trillion by the end of 2023. It has also ‘pledged’ to keep interest rates at or close to zero. Since then, stock markets and other risky assets have soared in value.

The green line on the chart tracks to value of investments (Treasury and Mortgage Bonds) held by the Federal Reserve Bank. As you can see this has reached nearly $8 trillion in total. The red line is the S&P 500 Index which is a broad measure of the U.S. stock market. Note in particular, the sharp rise in stocks from the beginning of April 2020, which coincided with a significant increase in the amount of bonds purchased by the Federal Reserve Bank.

This chart shows price inflation over the last thirty years.
Source: FactSet

Clearly central bank actions do have a profound impact on a whole range of risk assets of which stocks are just one – albeit a very large one! This has also been joined by commodities, residential real estate and, of course, ultra-speculative assets such as Bitcoin.

Will this end? Yes, it will. This is why many economists and investment managers are so fixated on the level of inflation and question the resolve of our central bank policymakers to stick to their declared intentions of keeping interest rates close to zero and continuing to buy enormous amounts of bonds.

So, the recent inflation numbers are a concern.

The chart shows the rise in the overall level of price inflation (Consumer Price Index -CPI) over the last thirty years.

This chart shows the rise in the overall level of price inflation (Consumer Price Index -CPI) over the last thirty years.

A sustained rise in price inflation could prompt the central bank to renege on its intentions just as it did in the other direction in early 2019, having indicated very different policies in mid-December 2018. So far, Federal Reserve Bank Governors and Janet Yellen, Treasury Secretary, have presented a very sanguine argument indicating their belief inflation is purely a blip – in their words ‘transitory’. Looking at these charts, however, we may be forgiven for thinking that there has been a very different set of circumstances driving inflation than those we and our policymakers have been used to for at least thirty years.

Time will tell. But for now, the price of risk assets, including stocks, are likely to be driven higher even though normal volatility will produce occasional market corrections.

Trevor’s articles and contributions to The Berkshire Edge should not be construed as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation.  As an author with specific expertise, his contributions reflect his personal views and do not represent Renaissance Investment Group LLC.

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