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Markets and Economy

The Fed’s effect on stock prices

Stock valuations are growing far faster than the U.S. economy. Here’s why the forces pushing stocks to record highs go far beyond the Federal Reserve’s quantitative easing.


Key points:

  • Stock valuations are at record highs, and the market’s capitalization dwarfs the U.S. economy.
  • It’s a stretch to assume that the Fed’s quantitative easing strategy is inflating asset prices. The Fed has little influence over historically high corporate profits and improved business productivity, the main forces driving the market higher.
  • The pandemic may have accelerated the trends making businesses more profitable.
  • Unlike past bull markets, household spending has not kept pace with the recent growth in portfolio wealth. This implies that consumer demand could weather a market correction.

Has the Fed inflated asset prices?

A central bank’s purchasing of long-term assets, a policy called quantitative easing, doesn’t create new money or directly put more of it into circulation. Rather, QE creates excess reserves at private institutions, which then inject trillions of dollars of liquidity into the economy. But there is little evidence that excess reserves push up stock prices.

It seems highly unlikely that the Fed’s quantitative easing would cause stock prices to rise so rapidly while leaving the cost of retail goods and services relatively unchanged. It is true that QE has lowered borrowing costs, suppressing bond yields and shifting some capital toward the stock market’s higher returns.

  • Even without intervention from the Fed, interest rates are moving toward a lower natural equilibrium. This is likely due to slowing population growth—including the workforce—which limits the economy’s long-term expansion potential. 
  • The low interest rates are a global phenomenon. The 10-year U.S. Treasury yield is currently higher than the yield on government bonds issued by Germany, the U.K., Canada or Japan.

The Fed’s balance sheet has added $9 trillion since 2009, but it has not generated broad inflation throughout the economy.

 

Are stocks really overvalued?

Stock prices have climbed at an unprecedented rate, but so have corporate profits. In fact, equity prices are rising far faster than the overall economy is growing.

In recent years, the market’s capitalization has grown to double the size of the nation’s annual aggregate product. Historically, however, the capitalization of America’s publicly traded corporations has roughly equaled the size of the nation’s annual aggregate output.

  • In our globalized economy, corporate revenues are not tethered to the size of the U.S. domestic economy or that of other nations. Equities investors are buying a piece of future profits that will flow from across the globe.
  • With corporate after-tax profits capturing a historically high 10% of U.S. gross domestic income, corporations have undoubtedly become more valuable. (Since the end of World War II, after-tax profits have averaged 6% of GDP.)

The stock market is currently valued at 17.7 times annual earnings based on the FT Wilshire 5000 Index, a broad-based index meant to track virtually all publicly traded stocks. That’s modestly higher than the historic average of 16 times earnings.

  • Investors are likely pricing in anticipated earnings growth. Since investors expect future profits to be higher, they are willing to pay a higher multiple of current earnings.
  • If profits were to continue growing at their current pace, the stock market would be priced at 13.8 times its forward earnings.

 

What’s really driving the stock boom?

Profits are up, largely due to globalization, automation and falling corporate overhead. For many companies, the pandemic merely accelerated the adoption of productivity-enhancing technologies.

  • Rapidly growing consumer markets overseas are creating massive demand for exported goods.
  • In the U.S., automation is making workers more productive, and the worker shortage is compelling businesses to invest in productivity-enhancing technologies that can empower a smaller workforce. 
  • E-commerce is expanding the reach of sales and marketing.
  • Companies and workers are embracing remote working and teleconferencing tools, which reduces overhead costs for office space and travel.

The market’s rise has caused household wealth to surge, but consumption has been slow to climb in response to swelling portfolio values.

  • This implies consumer spending could weather a market correction, insulating the business outlook from market volatility.
  • While there is no guarantee of continued high profits, there’s scant evidence to suggest these trends will be reversed in the near future.

 

What to watch: It’s not the market’s daily gyrations, or the swings in individual share prices. Instead, watch the share of GDP captured by corporate profits—that’s the fundamental driver of current stock valuations.  

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