Who's Really Driving the Stock Market?

Former Federal Reserve chairman Alan Greenspan remembers the stock market boom under his tenure fondly. He wrote in his 2007 memoir: "People would stop me on the street and thank me for their 401(k); I'd be cordial in response, though I admit I occasionally felt tempted to say, 'Madam, I had nothing to do with your 401(k).' It's a very uncomfortable feeling to be complimented for something you didn't do."

For a man never short on ego, he may have been underestimating himself.

In one of the most startling studies I've ever seen, researchers from the Federal Reserve this week measured how much the stock market is influenced by...the Federal Reserve. Their conclusion: "Since 1994, [stock] returns are essentially flat if the three-day windows around scheduled FOMC announcement days are excluded."

The Federal Reserve announces what it's going to do to interest rates eight times a year at Federal Open Market Committee meetings. These are scheduled in advanced and well-publicized, so investors know exactly when the goods are coming.

Since 1994 (when the Fed started publicizing its moves), the S&P 500 has risen from 450 to 1300. But remove the 24 hours just prior to FOMC announcements, and returns fall to almost nothing:

Source: Federal Reserve.

The researchers note: "More than 80 percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements."

Might some of this be a coincidence? Highly doubtful. My colleague Matt Koppenheffer took market data going back to 1994 and randomly removed 136 days (eight per year for 17 years, or one for every FOMC meeting). The difference, compared with the unmolested market returns, was trivial. We ran the simulation several hundred times, removing different sets of random days. Nothing came within a third of the skew caused by removing the days shortly before FOMC meetings.

This doesn't mean Fed policies have been responsible for the majority of the market's rise since 1994. After-tax corporate profits have increased fourfold since 1994, or more than double after inflation. Cellphones in 1994 were brick-like boxes, less reliable than carrier pigeons. Today you can stream live video on an iPhone. That's real innovation and progress that accrues value to shareholders. The Fed has played an enormous role in boom-and-bust cycles and has inflated asset prices for decades, but it's hardly the only driver of long-term market returns.

And when the researchers looked at the returns of bonds and currency exchange rates -- whose values should be more sensitive to Fed policy -- in the day before FOMC announcements, they didn't "find any differential returns ... on FOMC days compared with other days." That's not to say Fed policy didn't inflate the values of those assets -- indeed, almost by definition, it did -- but the effects weren't concentrated into a single day like they were in the stock market.

Why is that? I think it's a good example of how short-term and headline-driven stock markets behave. The stock market has been dubbed "the bond market's idiot kid brother," which seems appropriate here. Back in the '90s, CNBC hyped what it called the "briefcase indicator," using a live video feed of Alan Greenspan's morning walk from the Fed's parking lot to his office to gauge the thickness of his briefcase. If it was thick, it meant he was studying hard and preparing to make big changes. If it was thin, his mind was clear, and interest rates were likely to be left alone. This went on for years before people realized how ridiculous the theory was.

But the amount of short-term, carnival-barker thinking that permeates markets has, I think, gotten progressively worse over the years. Bond markets tend to process information in measured, calculated ways. The stock market, unable to think past next Tuesday, takes the binge-and-forget approach. Over the long haul, stocks are driven by business fundamentals, but any given day's movements are almost entirely headline-driven.

Just after I read the Fed's report, a news article crossed my screen. "Nearly two-thirds of the 30 investment experts surveyed by CNNMoney agree that the Fed's latest move to extend its so-called Operation Twist policy was warranted," it read.

Can you blame them?

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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  • Report this Comment On July 13, 2012, at 5:38 PM, MarquezDLS wrote:

    So, okay, I understand the point of the article is that this is a very silly fact, a ridiculous basis for the motion of the market. However, it's also true, right? Silly or not, it's true.

    So my question is, knowing it, how can one capitalize on it? What plays can be made around those days?

    Are there actions that make sense out of this senseless behavior?

  • Report this Comment On July 13, 2012, at 6:11 PM, xetn wrote:

    I personally believe the Fed is greatly responsible for the money flowing into the markets. This happened during the 20's and like all monetary inflation, ended when the Fed decided that price inflation was beginning to increase and shut down the monetary creation. This resulted in the '29 stock market crash and the onset of the great depression. We see the same kind of monetary creation, stock market boom of the '90s and the halting of the Fed's action leading to the 2000 market crash. This was followed by the next round of monetary inflation resulting in the real estate bubble occurring in the 2000s and, again, the Fed changed course and then the bubble burst. We now have had several trillion dollars created by the Fed's failed efforts to jump start the economy.

    The problem with the Fed's monetary inflation (creating money out of thin air) is that the money enters the economy in stages. First receivers get the money first (banks, etc) and then it starts filtering down through different levels until finally, the people with fixed incomes get the new money last. The first receivers get to spend the new money at old prices and much of their money goes into assets such as the stock market and commodities.

    I would guess that the Fed will again be forced to change course in the near future with another resultant market crash.

  • Report this Comment On July 13, 2012, at 6:30 PM, Gorm wrote:

    Think about it. Europe is in the shi**er. Japan is still stuck in its malaise. Brazil, India and China are contracting, the latter's GDP sliding from 8.1% to 7.6%, the US future (dysfunctional leadership and fiscal cliff plus data) is, at best questionable, plus consumer sentiment slips to a 7 month low and STILL markets are up - BECAUSE - investors think conditions are BAD ENOUGH the Fed will implement a QE3. What does that say?

    Gorm

  • Report this Comment On July 13, 2012, at 9:46 PM, TrojanFan wrote:

    One of the thing that I find so disturbing about this is the misincentive that it implies.

    This basically implies that the participants in the market that are rewarded most are the ones that become the best at anticipating and front-running the FED's actions on interest rate policy over the long-term. Is that really where we want these folks to be channeling their collective and considerable intellectual energies. What happened to the productive and efficient allocation of capital? I thought that was the whole point of capitalism.

    It seems to me that we would be well served by our policy makers doing more unpredictable things more often to clobber these guys and cost them some serious amounts of money occasionally to disincentivize this misguided behavior.

    That way folks who actually productively allocate capital would see their actions more greatly rewarded and they would therefore earn a greater financial voice in charting the course for the markets and setting the economic agenda for the nation. Instead as things presently stand, the bulk of the markets rewards would seem to accrue to folks who spend most of their time on telephone calls to staffers and other insider connections at the FED chasing after leaks all on phone calls of course and not in writing or in person or in ways that can get traced back to them that could lead to their ultimate prosecution, assuming of course that insider trading laws were evenly and uniformily enforced which, of course, they are not.

    I find the level of corruption that exists in our markets nauseating at times, I have to admit.

  • Report this Comment On July 13, 2012, at 11:04 PM, watt99 wrote:

    Did you really take my post down?

  • Report this Comment On July 14, 2012, at 10:41 AM, sigiam wrote:

    To the extent that captialism is ruled by capital, capital is ruled by humans and humans ruled by emotion, we would be irrational not to account for the markets irrationality. Don't get me wrong, I'm a huge value investor, but ultimately the value of anything is only what someone else is willing to pay for it, so even value investors must be cognisant of the average investors psyche... We do this all the time as value investors by estimatting what we think a company is worth, and capitalising on arbitrage between that value and the mkts pricing. A one day options trade designed to capitalize on the irrationality of others is really no different. If we want to beat the mkt we need to understand and be one step ahead of what drives it... if that means becoming experts in the psychology of stupidity, than by all means... it's the only inteligent thing to do... Foolish? Maybe... just so long as we can find a bigger fool.

  • Report this Comment On July 14, 2012, at 11:21 AM, kahunacfa wrote:

    Of course Federal Reserve Monetary Policy and interest rate move control the valuation levels of the stock market.

    It is well established that the value of an individual stock and the value of the Stock Market-over all is controlled, at least in large part by the prevailing and expected levels of the interest rate. Emperically, the usual best interest rate to use is the rate of the U.S. Treasury 10-year note. Take that as the "Risk-Free" rate.

    The correct discount rate to use to value the market or an individual stock for that matter is:

    Risk-Free Rate + Market Risk Premium + Asset Risk Premium.

    The Federal Reserve System controls the short-term interest rate, specially the Discount Rate and the Federal Funds rate. Longer-term interest rates are built-up from the short-term rate and Market intermediate to long-term Fed. Policy Expectations.

    The Stock Market Risk Premium varries somewhat from time to time; it is usually centered around about 3%. The specific asset or company risk premium varries greatly from near zero for an established Blue-Chip Consumer Brand Staple Company such at Proctor & Gamble or Johnson & Johnson to higher levels for a small capitalization, high growth technology company.

    For my investments, I generally use a 25% discount rate because that is the lowest rate of return I am willing to accept on a long-term, publcally traded investment.

    For Venture Capital Investments the discount rate ranges from 50% to 95% or so. Last VC portfolio returned an annual 58.4% compounded 1992 - 1995 <Audited>.

    Kahuna, CFA

    Investment Professional

    1994 - Present

  • Report this Comment On July 14, 2012, at 1:31 PM, vidar712 wrote:

    @MarquezDLS

    "So my question is, knowing it, how can one capitalize on it?"

    Isn't it obvious? Just time your buys to be two days prior to the schedule fed announcement. All of your gains will be made the day after you buy.

  • Report this Comment On July 14, 2012, at 4:51 PM, Tomohawk52 wrote:

    If the idea that the market moves when the Fed releases its reports becomes general knowledge then probably the effect will wear off, at least in part. So maybe to stay ahead of the curve you will have to do things a week before. But if everyone starts doing that then its two weeks ... and if they start doing that ...

    This reminds me of the experiment where they ask a room full of people to pick a number from 0 to 1000 with a prize given to the person who can come closest to guessing a number equal to 2/3 the average of everyone including the guesser. If everyone assumes that everyone will make certain assumptions the average number is going to be MUCH smaller than say 500 would be in this example.

  • Report this Comment On July 15, 2012, at 1:53 PM, kahunacfa wrote:

    Went to an Economic Event held in Kansas City, Missery whewre Greenspan was presented with the Truman Avard for Excellence in Economic Policy. Seated at a table mostly populated by Economics Professors from the University of Missouri, Kansas City. The table had many questions for King allan Greenspan. He made a short speach accepting the undeserved award and left immediately via a side door exit.

    The event was HUGELY disappointing and NOT worth the over one hundred dollar price of Admission.

    The event did confirm my impression that Greenspan is a way, way over-rated Economist and former Chairman of the Federal Reserve system. Greenspan stayed in that post far, far too long.

    The Current Chair of the FRB Uncle Ben Bernanke is a far, far smarter and better Economic policy planner than was Greenspan whose blind, over-relience on the Free Market Economy caused the Mortgage Market implosion and the last Depression which the United States is still slowly crawling its way out from under with great difficulity, I might add.

    Kahuna, CFA

    Investment Professional

    1974 - Present

  • Report this Comment On July 16, 2012, at 11:31 AM, dag154 wrote:

    So you are saying that interest rates affect the value of Shares. OMG!

  • Report this Comment On July 25, 2012, at 3:40 PM, pbk100 wrote:

    It's not simply that interest rates affect the value of shares - apparently they retroactively affect the value of shares.

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