Tuesday, April 9, 2013

The Stock Market Rally and the Fed

A common refrain in the financial press is that we are experiencing a “Fed induced rally in the stock market.”  According to this popular account, the Fed is drowning the market in liquidity resulting in low interest rates that have driven up stock prices.  Does that make sense?  The question cannot be answered in the abstract – it requires a model for evaluating the level of stock prices.  Whereas valuing individual stocks is particularly tricky, it is less difficult to value the market as a whole because the constant growth assumption is much more applicable to the entire market than to individual stocks.

The constant growth model implies that the level of stock prices is given by the equation,

 Stock price level = Next year’s expected earnings / (k-g). 

The Fed’s impact on the stock market comes into play via the denominator, (k-g), so let’s take that apart.  The g is the easier part.  It is the rate at which earnings are expected to grow.  As such, it includes two components.  The real growth rate in earnings plus expected inflation.  The discount rate, k, is the sum of three components - the real rate of return on long-term Treasury bonds, plus expected inflation, plus a premium for the risk of investing in common stock versus Treasury bonds.

            Notice first that when calculating (k-g) expected inflation disappears because it is included in both k and g.  In addition, there is no apparent reason why a loose Federal Reserve policy would alter the risk of investing in common stock compared to Treasury bonds, so let’s set that term aside.  Putting the pieces together, for the Fed to decrease (k-g), and, therefore, increase stock prices, it must either drive down the long-term real rate of interest or increase long-term expected real growth in earnings.

            First, as to real interest they are definitely low by historical standards.  Currently, the real yield on a ten-year Treasury TIP (an inflation protected bond) is -0.69% (yes, it is negative, that is not a typo), well below its long-run average of more than 1.50% prior to the financial crisis and the change in Fed policy.  However, despite all the Fed’s effort future real growth in earnings is also depressed relative to the time before the crisis.  The question is by how much?  It is hard to believe that expected real earnings growth has dropped more than a percentage point.  Assuming that the Fed is responsible for the substantial drop in real interest rates, then yes it looks like at least part of the current stock rally is Fed induced.  That should serve as a warning to investors.  Watch the ten-year TIP in conjunction with Fed policy.  If the Fed begins to tighten and the ten-year TIP starts to rise, it could be bad news.

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