Is "Easy Money" The Cause of the Market Rally?

Writing in the London Telegraph yesterday, columnist Ambrose Evans-Pritchard commented on the schizophrenic nature of the global equity rally.

Recent economic data is showing a slowdown in economic activity in many parts of the world, which normally would lead to market weakness.

However, it seems that investors are viewing economic weakness as bullish for stocks, since it means a continuation of massive central bank intervention.

Here's an excerpt from what Evans-Pritchard wrote:

The latest poll of Morgan Stanley's top clients from across the world says it all.
Chief economist Joachim Fels tells us that not a single investor at the bank's Florence forum thought the world economy would rebound with any strength later this year.

Just a quarter expect a return to trend growth. Some 57pc think there will be no escape from the "twilight" conditions afflicting the western world, and 20pc expect an full-blown global recession. That is a remarkably bearish set of views. Yet the same investors are overwhelmingly bullish on stocks and property.

This schizophrenic exuberance seems entirely based on the assumption that QE and central bank largesse will keep the game going, flooding asset markets with liquidity. Indeed, 80pc think the ECB will cut rates again, and half think it will have to swallow its pride and join the QE club in the end.

Four fifths think equities will gallop on upwards over the next year. Complacency is rife. "It became very clear – and many investors were quite explicit about this – that markets are lulled by the lure of liquidity resulting from negative real interest rates and global QE," said Mr Fels

http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100024618/schizophrenic-investors-expect-slump-bet-on-boom/

However, in that same column, Evans-Pritchard cites another paper which questions the assumption that markets are rallying solely because of central bank policies.

Scott Sumner of Bentley University in Waltham writes a blog titled "The Money Illusion".  The blog has quietly become one of the most widely read sites on economics in the financial community.

In his most recent note, Sumner questions whether monetary policy is really as easy as widely assumed. 

While interest rates are low in Europe, for example, bank lending remains tight, which is exacerbating weak economic trends.  Low interest rates, according to Sumner, do not necessarily mean easy monetary policies.

And as far as stock prices being buoyed by central bank liquidity, Sumner writes the following:

Is there any excuse for the press to still be talking about “easy money” throughout the developed world?  (A view that seems to be based on little more than low interest rates.)  I mean seriously, after the last 6 months in Japan, how can people still equate easy money with low rates?  Just to refresh your memory, Japan’s had near zero rates for 16 years and nothing has changed in the past 6 months.  Yet when you talk to finance-types you get the impression the current stock market booms are due to low interest rates caused by easy money.  That “easy money” policy of low rates  brought the Japanese stock market from 39,000 in the early 1990s to 8675 by mid November 2012.

http://www.themoneyillusion.com/?p=21215

I am not an economist, but I think that Sumner is right.  Stocks are rising in part because of low yields on other investment vehicles, but corporate earnings are also improving, albeit at a sluggish rate.

On an inflation-adjusted basis, the S&P 500 today stands at roughly the same level as it was in 1997.  Perhaps some of the recent rally could also be attributed to the fact that stock prices have lagged the growth in Corporate America.

We Are Prisoners of Our Past

Investors Have Their Eyes on the Past

Even though interest rates are at historic lows, and despite repeated warnings from economists and analysts that bond funds at today's yields are risky, investors continue to move money into fixed income.



According to Merrill Lynch, investors have poured more than $94 billion into bond funds so far in 2013.

Equity fund flows have picked up - last week a whopping $14 billion moved into stock funds - but more than half of the equity flows have been into exchange-traded funds (ETF's), which are typically trading vehicles rather than long-term investments.

What's going on here?

Jason Zweig had an excellent piece in the Wall Street Journal earlier this week about investor psychology. 

Zweig wrote that most investors who are active in the market today have never experienced a true bear market for bonds, which means they have a hard time  visualizing how one could lose money in fixed income investing:

Today’s bond investors have lived through more than three decades in which bonds almost never went down. So, even though everyone talks about the coming bear market in bonds, most people can’t imagine how painful it could be, warns David Allison, a partner at Allison Investment Management in Wrightsville Beach, N.C.

That’s true not just for individual investors but for professionals as well: The average age of a portfolio manager, according to the CFA Institute, is 43 – meaning that the last bear market in bonds ended when the typical portfolio manager was around 10 years old.

Meanwhile, unless you were active in stocks in the 1980's and 1990's, you probably have never experienced a true bull market for stocks:

For today’s stock investors, the reverse is true. The past 13 years have been gut-wrenching, with the Standard & Poor’s 500-stock index collapsing 38% between 2000 and 2002, then roaring up until 2007, then losing half its value between 2007 and 2009, then bouncing back again. No wonder nearly a third of investors think the stock market went down last year, even though the S&P 500 gained 16% in 2012.

http://blogs.wsj.com/moneybeat/2013/05/14/why-investors-cant-imagine-a-collapse-of-the-bond-market/

Gillian Tett of the Financial Times wrote (another) bearish column on stocks in this morning's edition.

One of the most respected financial journalists in today's press, Ms. Tett typifies the widespread belief that stocks are floating on a air of undeserved optimism, and that bad times surely must be ahead:

Are the markets going mad?  That is a question many investors might have asked in recent weeks, as stocks in the UK, eurozone and the US have soared - even as bond yields decline.

http://www.ft.com/intl/cms/s/0/0810ce9a-be2c-11e2-9b27-00144feab7de.html#axzz2TaD7e700

Tett goes on to argue that because none of the "traditional" correlations have held true in recent times - that is, correlations that were correct in the bear market for stocks between 1997 and 2011 - all of the market's recent gains are only setting up for a larger fall somewhere down the road.

I suggest that Tett has become a prisoner of the recent past. 

She was more prescient than most in seeing the credit crisis of 2008, and wrote a best-selling book about the collapse of the derivatives market. Her argument that all of this is based on central bank easing is echoed by many, yet it ignores that fact that the S&P today stands no higher than it was in 1997 on inflation-adjusted basis.  

I am not saying that we may not suffer a correction at some point - based on history, we are long overdue - but the tendency to base investment decisions solely on recent history has rarely proved to be a successful strategy.