This past week I had an uncharacteristically snarky response to the latest entry in the “it’s all about QE” genre of market analysis:
Same data, past 10 years, or 520 observations compared to 13. R-squared 0.004! pic.twitter.com/LmhORrFQ7s
— Tim Duy (@TimDuy) December 31, 2019
Yes, my frustration with this line of reasoning – the supposed one-to-one linkage between the balance sheet and equities prices – got the better of me. My tweet prompted this response from Grant Thornton Chief Economist Diane Swonk:
Again, I empathize w your position on the vigor of the analysis. But, I am having a hard time finding the justification for the market’s moves in the fundamentals and worry how much perception is reality for markets.
— Diane Swonk (@DianeSwonk) December 31, 2019
I get this; I see it as a deeper question than the QE-equity link. The analogy to the late 1990s is relevant given the similarities between Fed policy now and then. Is the rebound in stocks this year foreshadowing something ominous? Has the Fed set the stage for the next bubble? Below is how I think about these questions.
To start off, and in answer to the question that is the title of this post, I can’t tell you whether stocks are overvalued or not. I don’t really know, but it is not obvious to me that we should assume stocks are overvalued. The answer to that question assumes a known “true” model of valuation. But there appear to be many models and I agree with Ed Yardeni here – the answer depends upon your particular valuation model. Many of the models I see floating around suggest stocks are overvalued (but that is perhaps Twitter bias), but I tend toward Yardeni’s intuition that the appropriate model should recognize the impact of lower inflation and interest rates.
Yardeni’s preferred model said (as of November) that stocks were somewhat undervalued. That seems reasonable to me, but as I said before, I don’t know the “true” model. I think instead of a different question: “Is the path of equities substantially different from my expectations of that path during an economic expansion?” That depends of course on how I set my expectations. I tend to look at longer-term trends during the post-1984 period (the Great Moderation). Something like this:
Here I included a trend line derived from the beginnings of two rate hike cycles. From a qualitative perspective, the exact dating isn’t particularly important. You can eyeball the trend from 1987 to 1995 and extrapolate it out, or use the trend between roughly the beginning of the Great Moderation to the Great Recession.
I see two dominant features in this chart. The first is a clear acceleration in equity prices in the late 1990’s. I see nothing similar in today’s environment. This doesn’t surprise me as I think fears of financial excess are overplayed, effectively a case of fighting the last war. I also think the Japanese experiences is relevant here. Despite decades of ultra-low interest rates, nothing like the asset bubbles of the late 1980’s has reoccurred.
So, no, I don’t think the Fed has either created a bubble or necessarily set the stage for another bubble. To me, the dynamics don’t yet fit. Still, the operative word is “yet.” If stocks gain another 20% this year (unlikely in my opinion), I will obviously reassess this position.
The second feature I see is a level shift down in the value of equities after the Great Recession. I don’t think this will be corrected via some trend-reverting behavior of the series (it is not stationary around a trend). I think a better explanation is that there was a break in the trend for some fundamental reason such as secular stagnation. This suggests to me that a less optimistic view of the world has already been priced into equities. This I find interesting. I think the dominant view is the the trend path of equities should be flatter (?). To what extent has that view incorporated the possibility that a downward shift in the level of equities has already occurred?
This view better highlights the 1987 run-up in equities though that ended more quickly than that of the late-1990s. As for the current cycle, the path of equities is pretty much exactly where I would expect in a continued expansion.
Zooming in on the more recent history does still tell a story:
To me, the obvious time that equities exceeded my expectations was late 2017/early 2018 (around day 600 here). Stocks subsequently reverted and then proceeded roughly in line with my expectations (maybe a little pricey) before sliding below my expectations late 2018. In my view, the behavior of equities this year is not an unexplainable deviation from fundamentals but an expected recovery from excessive pessimism. Is there excessive optimism now? Nothing dramatic relative to my expectations given the ongoing expansion. That doesn’t rule out a correction, but absent a recession I would tend to view it only as noise around the trend.
(I do acknowledge the criticism that any similarity between my expectations and actual outcomes is attributable to dumb luck).
How does QE or, more generally, monetary policy fit into this story? To the extent that the Fed sets policy in a way designed to kill your recession call, it will support a general uptrend in equity prices over time because the economy remains in expansion. If the Fed commits a policy error or is unable to respond to a negative shock with sufficient speed and the economy tumbles into recession, I would expect equities to follow the economy down. With regards to the most recent months, I think the equity moves have more to do with a reduced risk of recession than repo-related balance sheet changes.
Bottom Line: I don’t think you need to fall back on “it’s all QE” to explain the behavior of equities this past year or this cycle. It appears to me that the general path of equities is what should have been anticipated given continued expansion. To the extent the Fed is involved, it is because policy moves have sustained the economic expansion. It seems best to view the Fed as endogenous to the system not some conspiratorial exogenous factor.