What Happens when the Music Stops?

By Chuck Gibson

A report from the Federal Reserve Bank of New York suggests that the bulk of equity returns for more than a decade are due to actions by the US central bank. The S&P 500 index would be more than 50 percent lower—around the 600 level—if the bullish price action preceding Fed announcements was excluded, the study showed.

Posted on the New York Fed’s web site, the study sought out to explain why equities receive such a high premium over less risky assets such as bonds. What they found was that the Federal Reserve has had an outsized impact on equities relative to other asset classes.

The report shows the market has a tendency to rise in the 24-hour period before the release of the Fed’s statement on interest rates and the economy, presumably on expectations Chairman Ben Bernanke and his predecessor, Alan Greenspan, would discuss or implement a stimulus (money printing) measure to lift asset prices.

The FOMC has released eight announcements a year at 2:15 ET since 1994. The study took the gains in the S&P 500 from 2 pm the day before the announcement to 2 pm the day of the statement and subtracted that market move from the S&P 500’s total return over that time span.

Without the gains in anticipation of a positive Fed action, the S&P 500 would stand at just 600 today, rather than above 1300.

You could conclude that correctly analyzing Fed moves is much more important than stock picking. If you wanted to generate the highest returns, you should just trade the stock market 24 hours before an FOMC meeting. Simply follow the trend for that 24 hours and you will outperform.

The chart shows the effect to be significantly pronounced in the aftermath of the tech bubble when Greenspan re-inflated stock and housing prices by slashing rates. It widens even further in the period since the financial crisis of 2008 as the market became beholden to the Fed’s use of its balance sheet to add liquidity to the market.

Within the past few months with Operation Twist winding down and investors eyes tearing up for more stimulus to keep the markets afloat, the Fed has “engineered” a 10% trading range for US stocks. Just when stocks fall to the bottom of that range, we get a touchy-feely, dovish Fed talking head that props them up with the siren calls of more liquidity.

For example, last week the markets experienced their first weekly loss in months. It would have been much worse but right on queue Chairman Bernanke squeezed the shorts a bit on Friday when he signaled further monetary action, or QE3, “could” come fairly soon. This reversed what was a down market at the open into a triple digit gain. As Friday’s market reaction showed, markets are still willing to rally on hope at least briefly. But after doing so since June, , they have reached the point where they need a lot more than just more hints, rumors, and stalled promises to prevent them from facing reality,

While all the talk and the actual monetary “stimulus” provide a floor underneath asset prices, it cannot go on forever without deleterious long term implications. Continual Fed action obscures signals for potential economic growth, hides risks of inflation, has a negative impact on employment, reduces family spending power, ”taxes” savers, creates asset bubbles, misallocates capital and alters returns on investment. Other than that it is a wonderfully, overused tool (he says with tongue firmly planted in cheek). As an investor the question you have to ask yourself is” when the music stops am I going to have a chair”? I recommend everyone be prepared for wild gyrations and potential fireworks this week and next as the world’s central planners bankers are meeting in Jackson Hole with the esteemed Chairman Bernanke speaking on Friday.