Is allocating capital in today’s financial markets investing, or simply playing along with a price setting scheme? Regardless of how one answers that question, I believe it’s indisputable that central bank policies have inflated asset prices, including equities. Therefore, when investors buy stocks they’re also buying a central bank premium. The duration and value of this premium is unknowable. Furthermore, several variables such as policy maker jawboning, economic data, and investor psychology can cause the premium to fluctuate. In my opinion, movements in the central bank premium currently have a greater impact on asset prices than fundamentals. As long as the central bank premium remains the most important determinant of asset prices, I continue to believe capital allocation in today’s market is not investing (see post “Is This Investing?”).
On Thursday of last week articles surfaced suggesting the Federal Reserve may eventually buy stocks or corporate bonds. From Reuters late Thursday, “Yellen Says Fed Purchases of Stocks, Corporate Bonds Could help in a Downturn.” And on Friday Bloomberg ran an article titled, “Summers Floats Idea of Sustained Government Stock Purchases.” As someone who longs for the return of free markets and investing, articles such as these are very disheartening.
Growing and maintaining asset bubbles is like rolling a giant snowball up a steep mountainside. As the snowball grows, it requires more and more effort (capital) to keep it from rolling backwards and squashing everyone and everything beneath it. With the profit recession possibly headed to its sixth quarter and the average company’s balance sheet more leveraged than before the last credit crisis, corporations are less likely to use their capital to buy back stock. Another source of capital, QE, continues globally, but remains on hold in the U.S. Even with asset prices near record highs, there remains a sense of unease regarding the economy and financial markets. To keep the giant snowball of asset inflation from reversing course and crushing investors, another source of capital is needed.
With an unlimited balance sheet and the world’s reserve currency, who better to create new capital than the Federal Reserve? As stated in my post, “Monetizing Cats”, the Federal Reserve’s unlimited balance sheet allows it to set the price of anything. While Fed policy has already indirectly inflated the price of equities, it appears the next round of QE could include some form of corporate nationalization and price setting (if eventually allowed). In a world of “I’ll Be Gone, You’ll Be Gone” central banking, keeping equity prices inflated through direct purchases shouldn’t be surprising. No one at the Fed, or in Washington for that matter, wants to be tagged with a Greenspan-like legacy of bubble blower. Direct purchases of stocks could be used in an attempt to delay the inevitable end of the current market cycle — buying policy makers enough time to hand off the monetary baton.
While many investors will undoubtedly welcome another price insensitive buyer of equities, central bank purchases would not be a healthy development for the asset management industry. The more involved the government becomes in the allocation of capital, the less need for capital allocators. If central banks set prices and eliminate risk premiums, the need for thoughtful analysis and the pricing of risk is reduced significantly. Due to my extraordinarily expensive opportunity set, I recommended returning capital to clients by choice. Assuming asset prices continue to be influenced more by policy than fundamentals, other active managers may not be as fortunate – the choice could be made for them.
Other jobs and industries would also be impacted by further policy intervention. Will the financial media be necessary if free markets are permanently replaced by central bank price setting? An excerpt from an article in the future may read, “Today the Federal Reserve raised Facebook to a Strong Buy with a $175 price target. Commenting on the new price, which will be set tomorrow by the open market committee, Janet Yellen said, ‘Initially we thought $160 was good. However, after further discussion, the committee decided that if $160 was good, $175 would be better.’” Sell side research would be affected too and replaced by guesses on new “appropriate” prices and the percentage of the float being nationalized.
This all sounds crazy doesn’t it? But didn’t monetizing $3.6 trillion in Treasuries and mortgages sound crazy ten years ago? It’s all very crazy, but very real. Policy makers and influential “experts” are now openly talking about the Federal Reserve following the lead of the ECB and BOJ and buying stocks and corporate bonds.
A chart of the world’s major central bank balance sheets looks similar to tech stocks in 1999 – further evidence we are in a central bank induced bubble. Will the monetization of stocks be the final phase before the Fed’s latest bubble pops, or will intrusive central bank policies and artificial asset prices be with us for years to come? For the sake of free markets, myself, and the remaining disciplined investors clinging on to their careers, I hope it pops soon. I can’t speak for others, but I sure can’t wait to invest again.