The stock market is not the economy, but the returns of indexes reflect a forward-looking lens into company earnings, which should be a reasonable proxy for economic activity. This all being said, as of this writing the Nasdaq is UP on the year. So what exactly is going on?
The “don’t fight the Fed” axiom will work until it doesn’t, and right now it still very much works. The myriad of programs the Fed is enacting doesn’t include outright equity purchases (yet); it is, however, undertaking a massive array of unprecedented bond buying.
The Fed's quantitative easing (QE) program has been buying $625 billion of Treasuries in some weeks, an amount that exceeds what the Fed would buy over the course of eight months in prior bouts of QE. It is also preparing to act on its plan to buy corporate bonds by way of The Secondary Market Corporate Credit Facility, and buying corporate bond ETFs in the open market, including junk bonds. Buying corporate bond ETFs is tantamount to buying every bond the ETF holds, which both provides liquidity and inflates prices.
But this is all bond buying, and interest rates were already close to zero, so how is this inflating stock prices?
The Fed may not be explicitly buying equities, but its purchases have indirectly caused hundreds of billions to flow into them by pushing bond prices higher. As they expand from government to corporate bonds, this very well may continue a cascading effect that’s already been occurring. Using the research of Vishnu Rajan at Essen Capital Management, there’s a compelling theory behind the rally that no one expected.
There were approximately $20 trillion in assets held by U.S. mutual funds at the start of 2020, and conservatively a quarter of that was in 60:40 mutual funds -- funds that must maintain portfolios of 60% equities and 40% bonds. These holdings are typically rebalanced the last week of each quarter.
These mutual funds possessed about $3 trillion in equities and $2 trillion in bonds (a large portion of which are U.S. Treasuries) on Jan. 1, 2020. The fastest bear market in history then happened, and by March 23, the S&P index was down 31.3% year to date. U.S. Treasuries collectively were up 9% in that same span. The 60:40 ratio was now significantly out of whack, relegated to 48:52, or roughly $2.06 trillion:$2.2 trillion.
The majority of rebalancing began to occur the last week of March (also the time the stock market bottomed). This activity returned the 60:40 mutual fund ratio, or approximately a $2.55 trillion to $1.7 trillion split. This means a huge $500 billion of equity buying, and a commensurate amount of bond selling.
The Fed announced its $1.2 trillion bond buying programs on March 23, providing an infinite bid for these bond rebalancing sales. It’s quite likely at least $500 billion of that $1.2 trillion sum was apportioned to rebalancing Treasury sales for mutual funds, among other investor classes. And it’s probable this activity goes well beyond the mutual fund space and this $500 billion figure for the reasons below.
Global pension funds hold roughly $28 trillion in assets, with a projected asset allocation 30% invested in equities, or about $9 trillion. Sovereign wealth funds have over $8 trillion in assets. They don’t have defined rebalancing we can draw from to produce the same extrapolations for mutual funds, but it’s very plausible most of the Fed's $1.2 trillion in bond buying went into buying U.S. government bonds from mammoth investors like these with systematic asset allocation mandates. The capital from these bond sales then funneled into the stock market.
The S&P had a market capitalization of $19.32 trillion on March 23. The conservative calculation of $500 billion in Fed bond purchases being used for rebalancing would have accounted for 2.6% of the total index at that time, enough of a catalyst for the rapid, sustained rally we’ve seen since as the Fed hasn’t let its foot off the monetary pedal.
As the Fed dips its foot into the corporate debt market while maintaining its QE programs, bond prices will continue to be artificially inflated, and this distortion should continue. The Fed obviously wants to support asset prices; I wouldn’t get in its way.