Central Banks and Equities - The New Monetary Policy

Updated July 2019

Given that the post-Great Recession economic expansion is one of the longest in history, one can be certain that the world's central banks will have to come up with an even more imaginative monetary policy than zero/negative interest rates and massive expansions of their balance sheets through the purchases of government bonds to stimulate the economy back to life.  If we look at the example of the Swiss National Bank (SNB), we may get an idea of how the world's central bankers will respond to the next economic contraction.

While the Swiss National Bank is not the first central bank that one thinks about when the topic of central banking is raised, is using some monetary policies that are rather unique in the world of central bankers.  While, like the rest of us, central banks are searching for yield on their foreign currency/exchange reserves which are used by central banks for one of seven reasons:

1.) to keep the value of their local currencies at or near acceptable exchange rates

2.) to keep the value of their local currencies lower than the United States dollar

3.) to maintain liquidity in case of an economic crisis

4.) to ensure that foreign investors have confidence in the bank's ability to protect their investments

5.) to fund certain sectors of their economy

6.) to ensure that a nation has the ability to meet its external obligations

...and, key to this posting:

7.) to improve returns on their reserves by investing in safe investments which historically have been gold and government debt

Let's take a closer look at the last item in the list, central banks investing in "safe investments".  Like the rest of us, central banks like to achieve a return on their "savings". 

According to the Official Monetary and Financial Institutions Forum or OMFIF, some central banks have "forayed into...equities, though most remain wary of proceeding too far in this direction".  On average, the global central banking system has a 1.5 percent allocation to equities.  OMFIF notes that the Swiss National Bank is an exception as you will see later in this posting.  As well, the Bank of Japan holds nearly $165 billion worth of equities although most of these are in exchanged traded funds (ETFs) rather than holdings of specific stocks and these ETF holdings make up just 3.6 percent of its total balance sheet, however, in January 2017, the BoJ owned 2.5 percent of the total market capitalization of the Tokyo Stock Exchange and nearly 58 percent of Japanese equity ETFs listed on the Tokyo exchange.

Now, let's look at the outlier, the Swiss National Bank.  According to its own website, the SNB owned the following assets as its foreign exchange reserves at the end of the second quarter of 2019:

Notice that 20 percent of the banks assets are in equities.  According to Trading Economics, at the end of the second quarter of 2019, the SNB had CHF 759 billion (US$766 billion) in assets, down from its all time high of CHF 772 billion (US$779 billion in April 2019 but well above levels seen prior to the Great Recession:

This means that the SNB held roughly $163.6 billion in equities at the end of Q2 2018.

Unlike the Bank of Japan, the SNB actually holds individual equities in its portfolio.  Thanks to the NASDAQ, we can see at least some of the equities were held on June 30, 2018 thanks to the filing of form 13-F or the Institutional Holdings Information that is filed with the Securities and Exchange Commission.  Here are the position statistics for the quarter:

Here is the sector weighting:

Here are the top holdings where the SNB's position has increased (2181 equities in total):

Here are the top holdings where the SNB's position has decreased (71 equities in total):

Here are the new positions (109 equities in total):

Here is the SNB's equity investing philosophy:

"The SNB is a purely financial investor. By replicating individual markets in their entirety, thereby diversifying its placements as broadly as possible, it pursues as neutral and passive an investment approach as possible. In a few cases, the SNB does not apply the principle of full market coverage. For example, it does not invest in equities of mid-cap andlarge-cap banks and bank-like institutions, to avoid possible conflicts ofinterest. In addition, it does not purchase shares of companies that seriously violate fundamental human rights, systematically cause severe environmental damage or are involved in the production of internationally condemned weapons."

As you can see, the Swiss National Bank has taken a rather unique position among the world's central banks, using its financial heft to invest rather heavily in equities.  While its relatively small size makes reduces its overall influence on the world's stock markets, the same cannot be said for the world's most influential central banks, most particularly the Federal Reserve.  Here is a table outlining the Fed's current reserves which are held in the System Open Market Account (SOMA):

Currently, the Federal Reserve is prohibited from owning equities, however, given the massive change in the Fed's operations (i.e. the unprecedented expansion of its balance sheet) during and after the Great Recession and the nearly $4 trillion in assets that it holds, should another significant economic crisis take hold of the global economy, all bets are off since it would be rather easy for Congress to pass legislation allowing the Federal Reserve to intervene in the stock market, potentially creating yet another reason why investors should be very cautious about investing in the current market that is only marginally connected to any kind of fundamental valuation and that could be further distorted by Federal Reserve intervention.

Let's close with this last rather sobering quote from the OMFIF report:

"Central banks’ accommodative monetary policies have ‘won time’ for these institutions as well as for politicians. This may delay the reckoning; it will not prevent it.”

The Stock Market's Achilles Heel

There is no doubt that the U.S stock market is on a tear with the appearance that there is no end in sight to the party, particularly with the latest GDP report showing 4.1 percent growth.  All that said, there is one worrying trend as you will see in this posting.

From the Financial Industry Regulatory Authority (FINRA), we have access to decades' worth of key investment data.  For the purposes of this posting, I have accessed FINRA's margin statistics that you can find here.  Let's look at FINRA's data for debit balances (i.e. margin debt) in customers' securities margin accounts going back to February 2010:

As you can see, margin debt has risen from a low of $263.202 billion in June 2010 to a high of $668.940 billion in May 2018, an increase of 154.2 percent.

FINRA also records the free credit balances in customers' securities margin accounts as shown here:

Free credit balances in margin accounts have actually changed very little over the past nine years, generally falling in the range of $160 million to $200 million.

If we take the two data sets and subtract the free credit balance from the margin debt, we get a picture of the overall size of the net margin debt as shown here:

Net margin debt has risen from a low of $90.294 billion in June 2010 to a high of $487.05 billion in May 2018, an increase of 439.4 percent.

Let's look at what FINRA had to say about the risks of margin debt back in January 2018 when margin debt was a "mere" $627.4 billion (November 2017 data point):

"Your firm can force the sale of securities in your accounts to meet a margin call. If the equity in your account falls below the maintenance margin requirements under the law—or the firm's higher "house" requirements—your firm can sell the securities in your accounts to cover the margin deficiency. You will also be responsible for any short fall in the accounts after such a sale.

Your firm can sell your securities without contacting you. Some investors mistakenly believe that a firm must contact them first for a margin call to be valid. This is not the case. Most firms will attempt to notify their customers of margin calls, but they are not required to do so. Even if you're contacted and provided with a specific date to meet a margin call, your firm may decide to sell some or all of your securities before that date without any further notice to you. For example, your firm may take this action because the market value of your securities has continued to decline in value.

You are not entitled to choose which securities or other assets in your accounts are sold. There is no provision in the margin rules that gives you the right to control liquidation decisions. Your firm may decide to sell any of the securities that are collateral for your margin loan to protect its interests.

Your firm can increase its "house" maintenance requirements at any time and is not required to provide you with advance notice. These changes in firm policy often take effect immediately and may cause a house call. If you don't satisfy this call, your firm may liquidate or sell securities in your accounts.

You are not entitled to an extension of time on a margin call. While an extension of time to meet a margin call may be available to you under certain conditions, you do not have a right to the extension.

You can lose more money than you deposit in a margin account. A decline in the value of the securities you purchased on margin may require you to provide additional money to your firm to avoid the forced sale of those securities or other securities in your accounts.

Open short-sale positions could cost you. You may have to continue to pay interest on open short positions even if a stock is halted, delisted or no longer trades." (my bold)

Remember that selling assets that are no longer under your control can be an extremely painful experience.  While the stock market appears to be on an endless journey upwards, as we found in 2008, no one (particularly not central bankers) saw this coming:

The unprecedented growth in margin debt is worrisome, particularly given that when the inevitable margin calls are made, the volatility in the stock market will be magnified as overly indebted Mom and Pop investors find that the system works against them.  Margin debt could well prove to be the stock market's Achilles heel.

How Fairly Valued is the Stock Market?

Updated February 22, 2018

One measure of equity valuation, informally known as the Buffett Ratio, is reputedly Warren Buffett's preferred measure of stock market valuation.  With the volatility in the stock market in recent days in mind, let's take a historical look at this measure of stock value which is measured as:

"the ratio of a nation's stock market capitalization to the overall gross national product of the economy".

Let's start with this graph from FRED which shows the total stock market value of all non-financial American companies, current to the third quarter of 2017, well before the market rose sharply in late 2017 and early 2018:

At $25.784 trillion, the market has risen by 201.1 percent from its Great Recession low of $8.564 trillion.

Here is a graph from FRED showing the Gross National Product since 1947:

At $19.729 trillion in the third quarter of 2017, the nation's GNP has risen by 36.4 from its Great Recession low of $14.465 trillion.  When you compare the growth in the gross national product to the growth of the value of Corporate America's equity, you can see how stock market valuations have far outstripped the growth in the economy as shown here:

Now, let's use both graphs to give us the ratio of the total market value of Corporate America to gross national product also known as the Buffett Ratio:

As you can see, the Buffett Ratio is just below the all-time high that it reached during the tech bubble at the beginning of the new millennium. 

It is generally considered that, if the stock market valuation is below 50 percent of the GNP, it is too low.  Between 75 percent and 90 percent, valuations are fair.  If it is above 115 percent, the market is overvalued on a relative basis.  Using the Fed's data, in late 2017, the market was over 130 percent of GDP.  Over the seven decades years from 1947 to 2017, the arithmetic mean Buffett Ratio was 67.59 and the median value was 63.99.  Values ranged from a low of 34.91 in 1982 to a high of 135.33 in 2000...and we all know how that movie ended, don't we?  The latest Buffett Ratio as calculated using the Federal Reserve data of 119.06 is 76.2 percent above the long term arithmetic mean and 86.1 percent above the long-term median.  Since the Federal Reserve Bank of St. Louis does not provide up-to-date total equity prices, let's look at an analysis by Jill Mislinski at Advisor Perspectives which is current to February 2018.  Her analysis using the Federal Reserve "Nonfinancial Corporate Business; corporate equities; liability, level" data (as I have used) shows the following:

Peak Corporate Equities to GDP: 151.3 percent (2000)

Great Recession Low Corporate Equities to GDP: 59.5 percent (2008)

Current Corporate Equities to GDP: 138.6 percent

When using the broader Wilshire 5000 Index to GDP data, she finds the following:

Peak Corporate Equities to GDP: 137 percent (2018)

Great Recession Low Corporate Equities to GDP 56.8 percent (2008)

By way of comparison, using the Wilshire 5000 Index, the previous peak of 136.5 percent was hit during the tech boom in 2000, a peak that the market has now surpassed.

A 2015 paper by Ted Berg at the Office of Financial Research (OFS) on the overvalued stock market concludes by noting that systemic crises are proceeded by bubbles and that four factors accelerate the emergence of asset bubbles:

1.) expansive monetary policies.

2.) lending booms.

3.) foreign capital inflows.

4.) financial deregulation.

Given that Corporate America has done this since the Great Recession:

...and that consumers have done this:

...I think that it's pretty safe to assume that, should the Fed continue to tighten and consumers, who are responsible for 70 percent of America's economy, cut back on their expenditures, we could see a continuation of the stock market readjustment over the longer term.  As well, it is largely the dumping of trillions of dollars into the economy by the Federal Reserve since 2008 that has "floated the stock market's boat".  All of that "cash" has to go somewhere.

Ignoring the Reality of Economic Policy Uncertainty

While the stock market is on a tear and there seems to be nothing that will interrupt its rise to the stratosphere, an interesting measure shows that the market is definitely in uncharted territory.

Three professors, Scott Baker from Northwestern University, Nick Bloom from Stanford and Steven Davis from the University of Chicago, have developed an index called the Economic Policy Uncertainty Index (EPU) which has a very unique basis; it is based on an analysis of news items, both past and present.

As we know, since the near-global financial meltdown, concerns about monetary, fiscal and regulatory policies have come to the forefront, particularly since it has become apparent that these policies created the crisis in the first place and have been relatively ineffective at creating pre-Great Recession levels of economic growth and stability.  To look at the role of policy uncertainty, the authors created the Economic Policy Uncertainty Index (EPU) by looking at the 10 leading newspapers in the United States going back to 1985 (the LA Times, USA Today, Chicago Tribune, Washington Post, Boston Globe, Wall Street Journal, Miami Herald, Dallas Morning News, Houston Chronicle, San Francisco Chronicle and New York Times) that contain the following "triple"; "economic" or "economy", "uncertain" or "uncertainty" and one or more of the following; "congress", "deficit", "Federal Reserve", "legislation", "regulation" or "White House".  Here is a graph showing the results:

You can see that the EPU spikes during each crisis over the past three decades including Black Monday in 1987, the first Gulf War, the Long Term Capital Management Crisis, the uncertainty of the 2000 election, September 11, 2001, the Gulf War, the Wall Street/Lehman/TARP crisis etcetera.  This is not terribly surprising but it shows a very close relationship between crises and the use of certain words in the media.

The authors then pushed their examination back in time to 1900, using six major United States newspapers (the LA Times, Chicago Tribune, Boston Globe, Wall Street Journal, New York Times and Washington Post) which shows the following with key events highlighted:

You will also note that there is an upward drift of the EPU over the past century which the authors attribute to the growing role of the government in the economy and the growing level of political polarization in the United States.

The authors used a similar method to create EPU indices for eleven other G10 economies including Australia, Brazil, Canada, Chile, China, Europe, France, Germany, India, Ireland, Italy, Japan, Korea, Netherlands, Russia, Spain and the United Kingdom along with a global index, some of which are shown here:  

  

1.) The United States:

2.) The United Kingdom which clearly shows the impact of Brexit:

3.) Europe:

4.) China:

When combined, this is what the global monthly EPU chart looks like when calculated using a GDP-weighted average of monthly EPU index values for the 17 nations that comprise two-thirds of the global GDP:

It certainly appears that the stock market, in particular those in the United States, is not reflecting any sense of the elevated levels of monetary, fiscal and regulatory uncertainties that exist in the "real world".  With the world's economy so interconnected, the record levels of the EPU index should cause investors to ponder whether now is the time to jump into the market or whether one should wait until the policy dust settles.

What is the Cyclically Adjusted Price-Earnings Ratio Telling Us About Stock Market Valuations?

In this, my last posting of 2016, I want to examine the story of the year, the rather miraculous performance of the U.S. stock market, particularly since Donald Trump's surprise win in November.  

Here is a chart showing the one year performance of the Dow Jones Industrial Average:

During the first two months of 2016, Dow fell from its 2016 opening level of 17,405 to a low of 15,460 on February 11.  It rose to its 2016 high (and all-time high) of 19,987 on December 20, an increase of 14.8 percent from its 2016 opening level.  It has retreated to its closing level of 19,762 on December 30, however, the index still shows a year-over-year gain of 13.5 percent.  Since corporate earnings are a key part of stock growth, by way of comparison, here is what happened to growth in after-tax corporate profits on a year-over-year basis since the beginning of the Great Recession:  

Profits in the third quarter of 2016 grew by 4.3 percent on a year-over-year basis, the strongest growth rate since the third quarter of 2014.

Since I haven't visited Robert Schiller's CAPE or Cyclically Adjusted Price-Earnings Ratio also known as the P/E 10 Ratio since August, I thought it was time to take another look at what this indicator suggests about the current level of the stock market.  The CAPE Ratio is defined as follows:

"...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.

Here is a line graph showing how the CAPE Ratio has varied on a monthly basis since 1881:

There are 1631 data points in Dr. Schiller's analysis which provide us with an average CAPE Ratio of 16.63 over the 135 year period keeping in mind that this includes the extremely anomalous CAPE Ratios that resulted from the tech sector bubble in the early 2000s.

Let's focus on the period of time since the Great Recession began at the end of 2007:

As you can see, the CAPE Ratio fell to a low of 13.32 in March 2009, the lowest level since March 1986 when the CAPE Ratio stood at 13.19.  Over the past six and three-quarters years, the CAPE Ratio has risen to its current level of 28.26 in mid-December 2016, an increase of 112.2 percent.  That said, the current CAPE Ratio is very high compared to the long-term average, in fact, at 28.26, it is 69.9 percent above its 135 year average as noted above.  

The current level of the CAPE Ratio suggests that the stock market is significantly overvalued, unfortunately, the CAPE Ratio does not telegraph when the stock market will return to normal valuations.  My suspicion is that the flight out of the bond markets have led investors into equities and that only time will tell when sanity returns and market valuations better reflect the reality of stagnant profit growth.