Since the axiom “Don’t fight the Fed†came into common parlance, we have all been aware that central bank policy is an important component of market performance. Most of us started out as security or business analysts and believed that fundamental factors like the pace of the economy, earnings growth and interest rates were the drivers of equity values. As we became more experienced, we began to understand the influence of psychology, which can be quantified by technical analysis. Since the end of the bear market and recession of 2008-9, and the fiscal stimulus and monetary easing that followed those tumultuous years, I have begun to appreciate even more the importance of central bank liquidity in determining the direction of equity markets. This is hardly a conceptual revelation, but I thought I would take a look at it quantitatively.
United States equities have tripled since the March 2009 low. The total capitalization of the Standard & Poor’s 500 has increased from about $6 trillion in March 2009 to $19 trillion today. Obviously this is not the total value of the entire U.S. equity market, because it leaves out much of NASDAQ and other peripheral markets, but most of the capitalization of U.S. public companies is captured by this index. Earnings have clearly driven a good part of that move; they have more than doubled from $417 billion in 2009 to $1.042 trillion in 2014.Â
Since 2008, the Federal Reserve balance sheet has more than quadrupled from $1 trillion in 2008 to $4.5 trillion. It took the Fed 95 years to build up a balance sheet of $1 trillion and only six years to go from there to the present level. The Federal Reserve was providing this stimulus to improve the growth of the economy, but it is my view that three quarters of the money injected into the system through the purchase of bonds went into financial assets pushing stock prices up and keeping yields low. If I am right, the Fed contributed almost $3 trillion (some may have gone into bonds) to the $13 trillion rise in the stock market appreciation from the 2009 low to the current level, earnings increases explained $9 trillion (1.5 x $6 trillion) and other factors accounted for $1 trillion. You could argue that the monetary stimulus financed the multiple expansion in this cycle.
In Europe, a similar condition has taken place. The EURO STOXX index reached its low in the fall of 2014 with a total market capitalization of €8.1 trillion. The current market capitalization is €10.5 trillion, an increase of about 30%. The balance sheet of the European Central Bank in October 2014 was a little over €2 trillion. It is up about 15% from that level today at about €2.344 trillion. An improvement in the outlook for earnings and the European economy helped here as well as in the U.S., but liquidity played an important role in the rise in the market. Like indices for the United States, the EURO STOXX doesn’t capture the full market value of all European equities.
In Japan, the balance sheet of the Bank of Japan began to increase sharply after reaching about ¥132 trillion at the beginning of 2012. It is now ¥327 trillion, more than doubling the early 2012 level. The market capitalization of the Tokyo Stock Exchange increased from about ¥254 trillion at the beginning of 2012 to ¥587 trillion currently, again more than doubling. Earnings played a role here as well, but the monetary liquidity could explain much of the market appreciation. The concept of the central bank playing a critical role in market performance has been brought home this year with the relatively strong performance of Europe and Japan because of Mario Draghi’s explicit policy of aggressive easing and the accommodative strategy inherent in Abenomics. In contrast, the Federal Reserve is poised to tighten (interpreted as the withdrawal of liquidity) as soon as it becomes comfortable that the economy can handle higher rates. As a result, the U.S. equity market has made little progress this year, while Europe and Japan are up in double digits in local currencies, and Japan is up in double digits in dollars as well.
