Patrick M. Lawler
How does the Federal Reserve measure the success of its asset purchase programs, or quantitative easing (QE), since the 2008 financial crisis – QE1, QE2, Operation Twist (OT) and QE3? Fed officials have said several times that among other benefits, its QE programs have helped boost U.S. equity prices.
St. Louis Fed President James Bullard included higher equity prices as one of the successful “financial market effects” of QE2 in March 2011, along with lower real interest rates, higher inflation expectations and a lower U.S. dollar. And Fed Chairman Ben Bernanke has cited higher stock prices as an outcome of the Fed’s purchases of mortgage bonds and U.S. Treasuries. The press has picked up the tune and has often focused on the impact of QE on stock market levels.
In our view, the connection between QE and the stock market warrants greater analysis. Before the announcement of QE3 in mid-September, the prospect of another round of QE raised questions about how it would impact the stock market. The possibility that the Fed would not take action led to ominous talk of a “Bernanke put” propping up the equity markets and fears that an end to QE would cause a dramatic decline in equity prices.
Based on our analysis, QE has not been the driving force behind rising equity prices in recent years. We found that since 2009, corporate profits have had a more direct relationship to stock prices. For clues on where the equity market is headed, we suggest investors focus on corporate earnings, dividends and cash flows and pay particular attention to valuations. At PIMCO, we acknowledge that the linkages between QE and stocks are complex. There are a number of arguments for the indirect effects of easy monetary policy on corporate profitability. For example, by purchasing mortgage-backed securities in the various QEs, the Fed drives down mortgage rates. Lower mortgage rates can result in increased housing market activity, which would in turn benefit the real economy and corporate profits.
Assessing the impact of monetary policyTo measure how successful the Fed’s balance sheet operations have been in determining the level of equity prices, we first examined developments since March 2008 when Bear Stearns collapsed and the financial crisis officially began through the end of August this year, prior to QE3.
Based on Figure 1, one might assume that the recovery in the equity market from its March 2009 low is a direct result of QE1, QE2 and Operation Twist.
If we are going to credit the Fed for lifting the stock market, however, we should examine how monetary policy can actually impact equity prices. Bernanke himself in an October 2003 speech at Widener University identified three key factors that should impact stock prices: “First, news that current or future dividends will be higher should raise stock prices. Second, news that current or future real short-term interest rates will be higher should lower stock prices. And third, news that leads investors to demand a higher risk premium on stocks should lower stock prices.”
He concluded: “The main reason that unanticipated changes in monetary policy affect stock prices is that they affect the risk premiums on stocks. In particular, a surprise tightening of policy raises the risk premium, lowering current stock prices, and a surprise easing lowers the risk premium, raising current stock prices.”
Put simply, the Fed can impact the price/earnings (P/E) multiple (a proxy for the discount rate which captures both risk-free real interest rates and the risk premium); the equity risk premium (the discount rate for stocks compared to the risk-free rate); or the level of earnings (a proxy for future dividends/cash flows). Given the rise in prices we’ve seen since the 2008 financial crisis, let’s take a look at the performance of these three factors for the S&P 500 – earnings, P/E ratios and the equity risk premium – over this same period of time.
Figures 2, 3 and 4 show a trough-to-peak rise in trailing operating earnings of 149% since the 2008 financial crisis (SPX LTM EPS of $40 as of 30 September 2009 vs. $99 as of 30 June 2012) and a 110% trough-to-peak rise in the price level of the S&P 500 (677 on 9 March 2009 vs. 1,419 on 2 April 2012). Over this period, we have not witnessed multiple expansion. Over the last 24 months, the S&P 500 has risen 33%, and the trailing LTM P/E has remained roughly constant at around 14 times. The equity risk premium has risen around 100 basis points over this same period as the U.S. 10-year Treasury bond yield has declined.
If we look at the change in the cyclically adjusted P/E ratio (CAPE or Shiller P/E), we can see that the P/E ratio has increased since the Fed began its balance sheet operations, but it has been relatively flat over the last 24 months. The equity risk premium, as measured by the cyclically adjusted earnings yield, has increased over the last 24 months, as seen in Figures 5 and 6.
So how successful has the Fed been in lifting equity prices? Is it driving the bus or simply along for the ride? In his 2003 speech at Widener University, Bernanke stated, “The statistical evidence is strong for a stock price multiplier of monetary policy of something between three and six, the higher values corresponding to policy changes that investors perceive to be relatively more permanent.” He also noted, however, “We should appreciate that unexpected changes in monetary policy account for a tiny portion of the overall variability of the stock market.” As our analysis shows, the most significant link between monetary policy and the stock market as identified by Bernanke – the risk premium – has in fact increased since QE was introduced. So to the extent the Fed launched QE1, QE2 and Operation Twist in order to raise equity valuations and/or lower equity risk premiums, it has been a failure. One could argue that the Fed has prevented valuations from falling and equity risk premiums from rising further, but it is clear they have not raised the rate at which investors are willing to capitalize $1 of earnings.
Instead, the performance of U.S. equities has been driven by the increased profits of U.S. corporations. QE may have had some effect on earnings, but it did not have a significant impact on equity valuations as measured by price-to-earnings multiples. While it’s true that P/E ratios did rise after the announcements of QE2, Twist and Twist 2, the moves were not sustained, and we believe were likely attributable to volatility around market sentiment.
Investment implicationsWhat does this imply for future stock returns? Future stock returns will be determined by today’s starting conditions, or valuation, and future earnings, dividends and cash flows. We are not trying to answer here where stock prices are going or whether QE3 is already priced into the stock market or what will happen to the stock market if there is no further QE. The appropriateness of the current market multiple or the path of future earnings is best left for another article.
Instead, we at PIMCO focus on individual companies, never forgetting that it is a “market of stocks and not a stock market.” As we have demonstrated, the Fed’s balance sheet activities have not resulted in a dramatic increase in the valuation of the S&P 500 as measured by price-to-trailing EPS or the Shiller P/E. Starting valuations in August 2012 are not significantly higher than they were in September 2010. (Although not our base case, an upside “tail risk” to consider is: the Fed may actually be successful at raising equity valuations/lowering equity risk premiums through further quantitative easing, and P/E multiples could approach their long-run, 50-year average of 16 times trailing/14.5 times forward EPS.)
What about the path of future earnings, dividends and cash flows? Many strategists and pundits have spoken about the potential for disappointment, given lower growth expectations and current high margins. PIMCO Managing Director Neel Kashkari discussed the question of margin sustainability in his April 2012 Equity Focus, “Newtonian Profits.” It is worth noting that the current multiple could already be discounting lower future earnings. Between 1960 and 2010, when the year-over-year change in CPI has been between 1% and 3% (it was 1.6% in July 2012), the S&P 500 P/E on forward earnings averaged around 17 times. Assuming an S&P 500 price of 1,400 and a 17 times multiple implies a forward 12-month EPS of around $82 – a 17% decline from LTM levels of $99.
So in our view, investors should look more closely at fundamentals and valuations for guidance in the year to come. Trying to predict the impact of QE – or lack of QE – on stock prices may be a distraction from what is really driving stock performance.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Risk Free Rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Statements concerning financial market trends are based on current market conditions, which will fluctuate.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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