Key Questions: Is the Federal Reserve Fueling a Stock Market Bubble?
The Federal Reserve and the stock market have become co-dependent, rendering selectivity and risk management of paramount importance.
It wasn’t very long ago when the Federal Reserve (the Fed) did not publicly communicate decisions involving monetary policy such as raising or lowering interest rates. Instead, market participants had to infer the Fed’s position by scrutinizing obscure financial operations conducted by the oxymoronically and vaguely named "Open Market Desk" at the Federal Reserve Bank of New York.
Given this opacity, it was not uncommon that the Fed could – and occasionally did – surprise the markets by altering its stance with little advance notice.
Since that time (roughly 25 short years ago), the Fed’s communications policy has been radically transformed. Today, after its proceedings, the Fed explicitly announces its decisions. It also provides a carefully worded press release highlighting its thought process, a range of forecasts that may influence future decisions and an internationally televised press conference to further enunciate its views.
Moreover, such activity occurs on a date and time that are shared with the world months in advance. As a result, while unanticipated policy shifts can still occur, market participants are far less likely to be caught off guard by the Fed than they were in the past.
According to varying histories of the Fed’s communication policy, these changes were intentional and designed to inject greater transparency and stability into the financial system. In addition, many acknowledge that once interest rates were reduced to zero and unconventional measures were instituted, nuanced details were needed to signal that the Fed would be there to fulfill its most important function of serving as the lender of last resort.
But has the Fed’s increased transparency come at a cost? With interest rates at/near zero, investors are incentivized to move out the risk curve to generate their requisite returns. "Cash is trash," some believe.
A few market participants have taken this incentive even further by using leverage in hopes of enhancing returns (not something we endorse). And while investors continue to be net sellers of open-ended equity mutual funds and related vehicles such as ETFs, trading in several individual stocks and their associated option contracts has surged to unprecedented levels.
As a result, valuations in certain stocks and the market as a whole have become elevated: At the end of last year, the forward price/earnings ratio of the S&P 500 Index traded at 27x, equaling the level it reached at the end of the tech bubble in the spring of 2000. Furthermore, the S&P 500 Index’s aggregate market value equates to 177% of US GDP, noticeably above the level it reached in December 1999 (159%).1
In response, several well-known investors have recently professed that a stock market bubble is at hand. These investors warn that some market participants have become unable to detect risk given the Fed’s near guarantee that it will keep interest rates low for years to come. "As with frogs in water that is slowly being heated to a boil, investors are being conditioned not to recognize the danger," cautioned one of the world’s foremost value investors.
In these pages and elsewhere, we have argued that elements of froth were evident, albeit mainly amongst certain stocks or groups of stocks that are linked by a common theme.2 Since then, those stocks have continued to climb, leading us to believe that such exuberance has swollen even further.
At the same time, however, we do not believe that the entire stock market is in a bubble. We acknowledge that the Fed and the stock market have seemingly developed a certain co-dependency that, over the long run, may paradoxically cause markets to become less stable, contrary to the Fed’s intentions to be more transparent. However, because of abundant liquidity, healthy consumer balance sheets (in the aggregate), and the belief that the economy will continue to recover as the COVID-19 vaccine rollout gains steam, we believe stocks should outperform bonds in 2021, notwithstanding some occasional bouts of turbulence along the way.
As such, with elements of overexuberance apparent, we believe investors will be well-served to institute the following:
- Scrutinize one’s current portfolio positioning and ensure robust diversification exists;
- Stay relatively balanced between offense and defense;
- Add inflation protection and incorporate other forms of income generation;
- Avoid the temptation to "over-liquify" one’s portfolio, although steps should be taken to maintain required spending obligations with confidence when necessary.
In short, in its attempt to become more transparent, the Fed and the stock market have become co-dependent, rendering selectivity and risk management of paramount importance. Pockets of speculation have emerged, but pragmatism should ultimately prevail.
For more information, please contact your Key Private Bank Advisor.