If you are trying to figure out why the stock market has been going up while the economy is going down, you probably don’t have to look much further than the Federal Reserve. The Fed has suddenly become the biggest single buyer of financial assets in the world. And all that buying is driving up prices.
This all started on March 23rd when the Fed announced it would spend an unlimited amount of money to support U.S. financial markets. The next day the Dow Jones Industrial Average was up 11%, its biggest single-day gain since 1933, and the market has roughly been going up since then.
What is the Fed Doing?
In a nutshell, the Fed is spending trillions of dollars to stabilize things in the short run, but likely making markets more unstable in the long run. Regardless of when the coronavirus crisis is over, the Fed’s expanding role in markets means we will probably experience more frequent booms and busts.
Essentially, the Fed has an unlimited pool of money that it can spend to buy things. This unlimited pool comes from the fact that the Fed can create money out of thin air, or out of thin electrical signals. With a few keystrokes, they can magically create money to spend. And when they decide to buy things, the price of whatever they are buying goes up.
Will the Fed Buy Stocks?
Now, this gets us to the question of will the Fed buy stocks? Traditionally, they have purchased bonds but not stocks. There are many technical issues around what types of bonds the Fed can buy, but the big change recently is that they have expanded what they can buy to now include bonds that carry risks of loss similar to stocks; these types of bonds are otherwise known as junk bonds. So, if the Fed is willing to risk money buying junk bonds to support the market, then they may be willing to go a little further and buy stocks.
This creates a situation where some investors think the stock market currently offers a “win/win” trade. If the economy gets better on its own, stocks will go up. But if it gets worse, the Fed will step in and drive stock prices up. So, either way, you win. This partially explains why the stock market continues to rise, even though the economy is posting numbers on par with the declines at the start of the Great Depression.
But if the Fed does cross the Rubicon and buys stocks, what does that mean for markets and investing?
To some extent, they are setting the stage for more volatile markets. One problem is that investors begin to act in ways that will cause the Fed to intervene. For instance, if the economy hits a roadblock of some sort, investors can sell aggressively to drive down asset prices, and then force the Fed to do something to drive them back up. If you like to trade, then you try to sell as markets are tanking, and then buy as you anticipate Fed intervention to inflate prices.
This is what happened at the end of 2018. The market was upset the Fed might raise interest rates. Traders pushed the market down 20% in a few short weeks and they forced the Fed to announce they would reverse course and lower rates. Stocks went up 30% in 2019, starting right after that announcement.
Fast forward two months into 2020 and as the virus issues began to impact the economy, sellers drove stock prices down 35% in the fastest decline ever. The Fed was then forced again to step in, and once they did, prices shot up. That was the quickest bear / bull market cycle ever. We went from a bear market (a decline of 20% or more) to a bull market (a gain of 20% or more) in just a few weeks. If you are sensing a theme, you are correct. Big moves up and down driven by a witch’s brew of aggressive trading and Fed policy changes, which creates a feedback loop.
If the virus comes back stronger than anticipated later this year, or if the economy simply fails to get back on its feet, and the stock market declines sharply again, what do you think will happen? The Fed will likely step in to save the markets, maybe this time with stock purchases. And once they do that, we can expect a pattern like this going forward each time the economy hits a roadblock.
This is how Fed intervention increases the odds of boom and bust markets. Consider that the volatility we have seen in markets over the last 15 years occurred when the Fed was limited to buying high-quality bonds, but if they move into junk bonds and maybe stocks, it’s likely to create bigger swings as traders try to anticipate the Fed’s market moving programs in the riskiest assets. Regardless of whether the Fed does move into stocks, the Fed has already become the biggest player in the markets, and markets will be permanently altered because of it.
Who Needs Fundamentals
The other big impact this has on markets is that investors become less interested in trading on fundamentals and more interested in trading on Fed monetary policy.
If the Fed is a big driver of stock and bond prices and they decide to change policies (or at some point run out of money to buy more financial assets), then it’s hard to know if the value of your portfolio will hold up. So, we do need a focus on fundamentals if we want to have some sense of what our retirement savings are worth, and a sense of the lifestyles we can live once we need our portfolios to support us in retirement. Thus, it’s dangerous for investors to rely on Fed bailouts as the primary support for their wealth because for any number of reasons Fed support could disappear.
For instance, a change in the power structure in Washington may cause a different approach. Instead of spending trillions to support financial values, our political leaders may decide to spend trillions to support state and local governments, or more generous unemployment benefits, or a universal basic income benefit to all Americans, and the list goes on.
The important thing to understand is Fed support is subject to change, and the less markets are built on fundamentals, then the higher the odds are that the bottom could fall out when policy changes. So, investors who want to protect themselves, should keep one eye on the fundamentals and the other on Fed policy.