Many say the Global Financial Crisis erupted in earnest in 2008; however, I wouldn’t argue too much with those who claim that it all started with the problems faced by two subprime hedge funds managed by Bear Stearns in the summer of 2007, even if equities only felt the full impact more than a year later. When the first signs of problems appeared, Bear Stearns officials went out of their way to downplay the incident. The hedge fund fallout represented a series of “isolated incidents”, it was “by no means a broader indication” of the bank’s performance, and concerns over the bank’s situations were “unwarranted”. These were only some of the many statements coming from Bear Stearns, designed to reassure a rather nervous investor community. (Source: Financial News (2013) – The collapse of Bear Stearns: Five years on.) Nine months later, it was all over. On the 15th March 2008, JP Morgan offered shareholders of Bear Stearns $2 per share for a company that had traded at $150 per share only a year earlier. The terms were accepted by the board of directors of Bears Stearns the following morning, and investors all over the world were mightily relieved. Now we could all return to what we thought we did so well, and that was to make money off the great bull market. Let’s not confuse genius with bull market, as my former boss always reminded me. Little did we know that it was going to get a lot worse in the months and years to come.
Today, a decade after Bear Stearns blew up, the ramifications of the Global Financial Crisis are still felt every single day. Extraordinarily low interest rates are only the tip of the iceberg. In so many ways, it is such a different world we wake up to every morning compared to the world we knew, and came to like, in pre-crisis times.
Some abnormalities in the New Normal
An example of something that has changed dramatically in recent years is the composure of the growth in earnings per share (EPS). No less than 72% of EPS growth in the S&P 500 between 2012 and 1H2017 was accounted for by stock buybacks, but Trump’s tax reform could change that – more about that in a moment. (Source: MacroStrategy Partnership LLP.)
Another thing that has changed in recent years is the investment community’s relationship with the Fed. To put it mildly, American investors have developed an obsessive love affair with the Fed. Anything the Federal Open Market Committee (FOMC) does is rewarded by investors, and I mean anything. In fact, they don’t need to do anything at all. As long as an FOMC meeting is held, investors get carried away.
Before 1982, the days on which the FOMC convened were just like any other day in the US equity market, but that changed with the arrival of the Great Bull Market. Since 1982, a full one quarter of the total cumulative return on US equities has been delivered on the eight days a year that the FOMC have met, regardless of whether interest rates have been lowered or not.
Even more noticeable, in the first few years following the Global Financial Crisis, the performance of the S&P 500 on the days that the FOMC convened was no less than 29 times higher than the average daily return (Exhibit 1).
In other words, the sheer presence of those meetings has had a much bigger say on equity returns than what the FOMC actually decided to do. By establishing QE, the Fed effectively created a considerable amount of moral hazard by force-feeding investors risk assets; hence the expression the foie gras market. (Note: I have borrowed the expression with gratitude from James Montier of GMO.)
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