- Stock buybacks have driven a significant portion of returns over the past decade. If the political climate swings the pendulum from capital to labor, that could lower valuations for stocks.
- With the market up 30% from the lows, many are wondering if the Fed is creating asset price inflation. Taking a look at history may reveal some answers.
The longevity of the stock market's recovery from the COVID crisis will depend in part on what happens between the balance of capital and labor, in my view.
In recent years, the US market has rewarded the owners of capital (shareholders), and many believe that this came at the expense of labor (hence populism). If the current crisis swings that pendulum back to labor, as happened decades ago in Japan and Europe, then that could have negative implications for share buybacks and, therefore, the payout to shareholders and, therefore, stock valuation. The US trades at a price-to-earnings ratio (P/E) of 20x while Japan and Europe trade at 14x. It's a big gap.
So from here on, we need to watch what happens to the political climate (this being an election year), and what impact that is likely to have on share buybacks. Depending on the regulatory environment, the government could outlaw or penalize share buybacks. Companies that are getting financial assistance during the COVID-19 crisis are already being prevented from buying back shares. The same is happening in Europe.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
So how are buybacks doing? So far this year the numbers are tracking about average as compared to the past 17 years. As I have pointed out in the past with my discounted cash flow model,* buybacks (or the payout ratio) have a large impact on the value of equities. So getting this right will be critical.
If we stay on this course (which is a big if, of course), it suggests that we will get around $550 billion in buybacks this year for the S&P 500. If I plug that number into my discounted cash flow model, I get a scenario very much consistent with my "Swoosh" recovery scenario (around 2,600 for the S&P 500).
Is the Fed inflating the value of assets?
The market is hanging in there for now, but how much is driven by the perceived Fed-induced asset price inflation? Most periods of quantitative easing (QE) have produced meaningful P/E expansion.
That is the idea, after all, behind QE—to force investors out of the risk-free asset and into riskier parts of the market. If that shift is not supported by an improvement in the real economy, then by definition it's a form of asset price inflation that drives the P/E multiple higher.
And if the Fed is printing a lot of money via QE, then the purchasing power of the fiat currency (the US dollar) should go down. That's the theory, at least.
It's important to distinguish between inflation in the real economy (wages, oil prices, etc.) and financial asset inflation. Financial asset inflation is, by definition, good for stocks, but could create an overvaluation if not supported by an improving economy. So when asset price inflation ends as the Fed steps away, it could leave the market vulnerable to correction. In the charts below, I've shown the stock market priced in dollars and gold. The latter can show hints of asset price inflation.
So let's dig into some history and see what we can learn about asset price inflation (or deflation) and the so-called money illusion that some accuse the Fed of creating today.
Reviewing the Great Depression, the 40s, and the Global Financial Crisis
What conclusions can we draw from 3 distinct historical periods? Did intervention by the Federal Reserve artificially inflate the S&P 500?
For the Fed rate, I show the nominal policy rate, as well as the shadow fed funds rate (both nominal and real). In a nutshell, the shadow fed funds rate incorporates unconventional Fed policy (QE), which allows it to be negative as well as positive. In other words, the real shadow rate should give us a good all-in-one sense of how accommodative or restrictive monetary policy has actually been throughout history.
For more detail on the shadow rate, here is a good explanation from the University of Chicago: The 'shadow rate' can measure the effects of QE.
Since the shadow rate only goes back to 1960, and because I want to look closely at the QE days of the 1940s, I took the liberty to curve-fit the pre-1960 history based on a simple regression between the nominal fed policy rate and the Fed's balance sheet relative to GDP.
During the Great Depression, the Fed clearly inflated asset prices by devaluing the dollar (via gold).
In 1933 the government debased the dollar by confiscating people's gold and then changing the price from $20 to $35, in effect devaluing the US dollar by 40%. As a result, from the 1932 low (indexed at 100), the S&P 500 (SPX) increased 5x to the 1937 top (511), while only increasing 3x in gold terms (to 294). During the days of the gold standard, that's the very definition of asset price inflation.
During the 1940s, Fed policy was extremely accommodative, yet the gains in asset prices were real and continued throughout the next decade and beyond.
From 1942 to 1946 the Fed capped interest rates at around 2% and increased its balance sheet 10-fold in order to monetize the government debt issued to fund the war. During that time, the nominal return of the S&P 500 was 3.1x (to 310) while the real return was 2.7x (to 270). Gold was at $35 the whole time.
At the same time, while the nominal Fed policy rate remained very low (1.0–1.5%), inflation ran very hot in 1943 and again in 1946, and this led to a collapse in the real shadow rate to −10% and later to −13%.
Despite the dramatic monetary stimulus combo of low rates and QE, the gains in the stock market during the 1940s were real and not a money illusion.
The Global Financial Crisis (GFC) produced an asset price inflation that boosted what I believe would have been a bull market anyway.
Measuring the markets from the March 2009 bottom until the February 2020 top, the nominal S&P 500 return is 5.5x (from 100 to 551), while the real return is 4.7x (to 465). Not much difference there, given the persistent low inflation of the 2000s.
In gold terms, however, the market returned only 3.4x (from 100 to 344 by February 2020). That's a big difference and shows that in gold terms there was indeed some asset price inflation going on during the past decade. But 3.4x is still a respectable return.
So, yes, in my view asset price inflation has been a factor since the GFC, but it's not a total mirage either. Through QE and zero rates (and the financial engineering that ensued), the Fed inflated the return of financial assets, but this study suggests that there would have been a bull market either way.
What happens now?
From here, in my view, the 2 critical variables in terms of the secular outlook are the tensions between labor and capital (and what happens to stock buybacks), and between inflation and deflation (which Fed policy attempts to affect).