Friday, August 19, 2016

How the Federal Reserve Blew Up the Stock Market

Sometimes after retirement, central bankers become surprisingly candid about the economy, their role in the economy and the Federal Reserve's role in how the economy functions.  In that light, here is a link to an interview on CNBC's Squawk Box with Richard Fisher, former President of the Dallas Federal Reserve Bank back in early January 2016 discussing the impact of China's economic slowdown on the U.S. stock market.  To help you digest this fascinating and surprisingly candid interview, I've posted a transcript of the interview below the video:

"Richard Fisher: What the Fed did, and I was part of that group, we front-loaded  a tremendous market rally starting in March of 2009. It was sort of a reverse Wimpy factor. Give me two hamburgers today for one tomorrow. We had a tremendous rally and I think there's a great digestive period that's likely to take place now. And it may continue. Once again, we front-loaded, at the Federal Reserve, an enormous rally in order to accomplish a wealth effect. I would not blame this [the 2016 selloff] on China. We are always looking for excuses. China is going through a transition that will take a while to correct itself. But what's news there? There's no news there.

Squawk Box: I guess the question Richard is: How ugly will it get? If you do see this big unwind of Fed Policy which fueled a 6 and one-half year bull market, what does it look like on the way down?

Richard Fisher: Well, I was warning my colleagues, don't go [inaudible] if we have a 10-20% correction at some point.  These markets are heavily priced. They are trading at 19 and a half time earnings without having top line growth you would like to have. We are late in the cycle. These are richly priced. They are not cheap.  I could see a significant downside.  I could also see a flat market for quite some time, digesting that enormous return the Fed engineered for six years.

Squawk Box: Richard, this digestive period, does it usher in an era where assets can't perform in the absence of accommodation?

Richard Fisher: Well, first of all, I don't think there can be much more accommodation. The Federal Reserve is a giant weapon that has no ammunition left. What I do worry about is: It was the Fed, the Fed, the Fed, the Fed for half of my tenure there, which is a decade. Everybody was looking for the Fed to float all boats. In my opinion, they got lazy. Now we go back to fundamental analysis, the kind of work that used to be done, analyzing whether or not a company truly on its own, going to grow its bottom line and be priced accordingly, not expect the Fed tide to lift all boats. When the tide recedes we're going to see who's wearing a bathing suit and who's not. We are beginning to see that. You saw that in junk last year. You also saw it even in the midcaps, and the S&P stripped of its dividends. The only asset that really returned anything last year, again if you take away dividends, believe it or not, was cash at 0.1%. That's a very unusual circumstance.

Squawk Box: Richard. This has been an absolutely extraordinary interview. For you to come on here and say "I was one of the central bankers who engineered the frontloading of the banks, we did it to create a wealth effect" and then you go on and tell us, with a big smile on your face that we are overpriced, which is the word that you used, and there would be some digestive problems,  are you going to take the rap if there is a serious correction in this market? Will you equally come on and say "I'm really sorry we overinflated the market", which is a logical conclusion from what you've said so far in this interview.

Richard Fisher: First of all I wouldn't say that. I voted against QE 3. But there's a reason for doing this. Let's be fair to the central banks. We had a horrible crisis. We had to pull it out. All of us unanimously supported that initial move under Ben Bernanke. But in my opinion we went  one step too far, which is QE3. By March 2009 we had already bought a trillion dollars of securities and the market turned that week. To me, personally, as a member of the FOMC, that was sufficient. We had launched a rocket.  And yet we piled on with QE 3, but the majority understandably worried we might slide backwards. I think you have to be careful here and frank about what drove the markets. Look at all the interviews over the last many years since we started the QE program. It was the Fed, the Fed, the Fed, the European central bank, the Japanese central bank, and what are the Chinese doing?  All quantitative easing driven by central bank activity. That's not the way markets should be working.  They should be working on their own animal spirits, but they were juiced up by the central banks, including the Federal Reserve, even as some of us would not support QE 3." (all bolds are mine)

As an aside, note that how, like Pontius Pilate of old, he washes his hands of any responsibility for the implementation of QE 3, the Fed's dying gasp at propping up the American/global economy.

Let's look at the key takeaway.  During the late stages of the Great Recession when it looked like the global economy might collapse on itself, Mr. Fisher admits that the Federal Reserve deliberately sponsored a stock market rally (i.e. created a bubble) to create a wealth effect to lure American consumers to spend and stimulate the moribund economy back to life.  At the time of the interview, Richard Fisher noted that stocks were "heavily priced", trading at 19.5 times earnings.  According to Robert Shiller,'s CAPE Ratio, here's what stock market valuations look like now:

Let's focus on the period from the beginning of 2007 to the present (July 2016):

The CAPE Ratio or Cyclically Adjusted Price-Earnings ratio which is also known as the P/E 10 ratio is defined as the price of stocks (or the stock market as a whole) divided by the moving average of ten years of earnings adjusted for inflation.  Higher than average CAPE Ratios suggest that there will be lower than average long-term annual returns and lower than average CAPE Ratios suggest that there will be higher than average long-term annual returns on stocks.  As of July 2016, the CAPE Ratio was sitting at 26.2, in the neighbourhood of its highest level since the end of the Great Recession when the CAPE Ratio fell to a low of 13.32 in March 2009.  Over the past 134 years, the CAPE Ratio has averaged 16.6; the value for July 2016 suggest that the market is significantly overpriced.  Thanks to Richard Fisher's candidness, we now know exactly why; the Federal Reserve deliberately took action to front-load a market rally in March 2009 when, coincidentally, the CAPE Ratio was at its lowest point since 1987.

I find it particularly interesting that a central banker is candid enough to admit that this entire post-Great Recession recovery has been engineered by the extraordinary interventions of the Federal Reserve and their fellow central banks in Japan and Europe and that, by Mr. Fisher's own admission, the Fed has no monetary ammunition left.  The broader stock market has risen based solely on monetary policy, not on fundamentals like growing profitability, controlled debt levels and improving total factor productivity.  As Mr. Fisher notes, the Fed "floated all boats" and, when the "tide recedes, we're gong to see who's wearing a bathing suit and who's not.".

Unfortunately, he suffered from a lack of foresight when he voted in favour of both QE 1 and QE 2, the unconventional central bank actions that started us down this very dangerous path.

1 comment:

  1. Thanks for a great article, I'm also surprised he was so candid. The real economy exist somewhere far from Wall Street and can be seen in parts of America where most of us live. After eight long years of near or zero interest rates, massive government deficits, and watching tons of money and stimulus being poured into the economy we remain mired in slow growth.

    In the end our future has a way of being tied to reality and certain economic laws as well as laws of nature that hope and delusion cannot defy. While these bonds can be ignored for a time the force they have over us at some point will suddenly pull us crashing to the ground. The article below delves into why the FED has not put us on the right path.