GMO’s James Montier and Philip Pilkington have a nice piece up on the vast distortion that Fed policy has created in equity prices over recent decades. According to the researchers, it may not be the ultra-low rates that have created such lofty asset prices, but the Fed’s willingness to step in at every market hiccup to prevent greater fallout that has led to the distortion.
Some of the highlights are below. The full piece can be read here.
…But, from 1985 onwards, removing fewer days began to have a major and increasing impact on the market. In fact, FOMC days account for 25% of the total real returns we have witnessed since 1984!
One of our bright young colleagues,2 who is considerably more statistically sophisticated than we, calculated that the chance of this occurring randomly was only 0.0086% (that is, 86 out of 1 million). As he put it, “The odds are astoundingly low!”
The Monetary Policy-Adjusted CAPE
We can use this insight to build a counter-factual picture of the world: a measure of the S&P 500’s valuation if the Fed didn’t have any impact on the animal spirits of investors. We simply take the return series for the S&P 500 and replace the days when the FOMC met with the average return on non-FOMC days (using an expanding window) and use this to then calculate the Monetary Policy-Adjusted CAPE. Exhibit 6 plots the standard CAPE and our adjusted series.
If we remove the impact of FOMC days, the CAPE looks to be significantly more mean reverting than it has over the last 20 years or so. The adjusted CAPE fits with our intution over this period: The tech bubble would not have gotten quite so big (although it would still have been the biggest stock market bubble in U.S. history) without the Fed’s help; in the wake of the GFC the market would probably have gotten down to the levels of valuation associated with a serious crisis (i.e., single-digit P/Es). Thus, if we believe this data we can say that post the GFC in particular the Fed has impacted the valuation of the stock market
significantly, preventing mean reversion to occur in the fashion that we would have expected.
…Betting on the Fed’s ability to generate continued market levitation seems like a dangerous game to us, but as Newton long ago opined, “I can calculate the motion of heavenly bodies, but not the madness of people.”