Investors probably underestimate the tailwind from global central banks quantitative easing. Over the last five years, the expansion of the Federal Reserve balance sheet has expanded and with it the S&P 500. In the chart below, by Michael Lebowitz of 720 Global we see this relationship.
(Source: 720 Global)
Deutsche Bank published a chart which shows the balance sheet changes from the four largest central banks. One could argue based on the chart below that the change went to zero on 3-4 other times as well. But we should keep in mind that valuations are today much higher and that over the last few years other central banks (eg. Swiss) and sovereign wealth funds (eg. Saudi) have been active in the market as well. So I’m not sure this chart is complete…
So is the relationship between Fed and S&P a coincidence? Time will tell but obviously low rates drive stock prices higher. This is because the market valuation is the summation of the future cash flows discounted back to today. If the discount factor is lower (due to lower rates) then the valuation is higher.
But there is also a behavioral issue at play as well. A recent WSJ article talked about a series of experiments by economics graduate students by Liam, Ma and Wang (link to their paper) which show that the lower the rates, the more risk investors are willing to take!
They asked people to choose how much to allocate between a risk-free asset and a risky asset. They kept the difference between the risky and risk-free at 5%. So groups were asked to choose between 5% risk-free and 10% risky, 4% risk-free and 9% risky, etc. As the graph shows below, the lower the risk-free rate, the more people wanted the risky asset despite the spread remaining the same!
It’s human behavior. So keep this in mind for next time you are looking at an opportunity and ask yourself “Am I being compensated enough for the additional risk I am taking?”