Conspiracies Aren’t Conspiracies And ‘Fundamentals’ Are Malleable

I would wager that I am, more than anyone else who writes regularly about markets and economics for public consumption, averse to conspiracy theories.

Regular readers are well apprised of my disdain for the dissemination of misinformation, both related to markets and otherwise.

With that obligatory caveat out of the way, let me just say that I find passages like the following (from a Bloomberg article published Saturday) exceptionally disingenuous:

Dennis DeBusschere, Evercore ISI’s head of portfolio strategy, says the relationship between changes in the Fed’s balance sheet and the S&P 500 is near zero, and the latest stock rally is consistent with improving economic data and earnings.

It’s not the latter part (i.e., the bit about improving economic data and earnings) that’s the problem, although if I wanted to, I could challenge it too. And, actually, I will, because it’s Saturday and readers like to be entertained on weekends.

I have, for months, noted that the data was gingerly inflecting for the better, so I’m hardly in the camp that revels in pushing a dour narrative. But just like Dennis appears to be doing (although I can’t say for sure what data he’s referring to) I can cherry-pick too.

DeBusschere says “the latest stock rally is consistent with improving economic data and earnings”. On the economy, that assessment depends heavily on what indicators you cite. Business investment, for example, slumped in Q4 for a third consecutive quarter. That’s the worst stretch since 2009.

ISM finally (and mercifully) bounced back into expansion territory in January, but it had spent the previous five months mired below the 50 demarcation line.

In other words, on ISM’s gauge (if not IHS Markit’s), the US economy had been in a factory recession since July. Stocks didn’t care.

On earnings, DeBusschere’s assessment assumes you’re willing to overlook the usual lowering of the bar headed into reporting season, and it also seems to gloss over the fact that with more than two-thirds of results in the books, the extent to which those results have come in ahead of estimates is bang in-line with the historical median (around 5%). Not exactly a breathtaking performance.

(Morgan Stanley)

More broadly, assuming profit growth does, in fact, end up being negative on the whole by the time all the results are in, it will mean that corporate America is in an earnings recession, with EPS having contracted for two straight quarters.

None of this is new, of course. The point is simply that so much of what you read about markets and the extent to which equities are or aren’t responding to the fundamentals, is little more than a series of perfunctory assessments delivered because someone was scavenging for a soundbite. You can everywhere and always argue the other side, as I just have.

But whereas all of the above is just me playing Devil’s advocate more than it is me disagreeing with the excerpted quote from the Bloomberg piece, I find the bit from that quote about “the relationship between changes in the Fed’s balance sheet and the S&P 500 is near zero” to be distasteful, at best.

It is well known that establishing a direct, mechanical, quantifiable link between balance sheet expansion and stocks is difficult, and the reasons why it’s difficult have been documented exhaustively.

That said, describing (or intimating) that folks who draw a connection between balance sheet expansion and equity prices are trafficking in conspiracy theories is to deny the rather obvious link between liquidity provision and financial asset performance.

“As the Fed has expanded the size of its balance sheet, we have been of the view that the resultant excess liquidity has been beneficial for stock prices and multiples”, Morgan Stanley wrote last month, adding that “the potential impact of the Fed on equities has been a central feature of almost all our client conversations”.

I documented Morgan’s latest efforts (and there have been previous attempts by every bank under the sun) to quantify the relationship last month, and you can read more in “What’s Behind The Rally? It’s The Liquidity, Stupid“. For our purposes here, just note that to deny this link is to implicitly deny the portfolio channel through which QE operates.

US equities managed another weekly gain despite ongoing concerns about the coronavirus epidemic, and although the visual in the top pane below is, most assuredly, a “chart crime” of sorts, it nonetheless makes an important point.

In the context of all this, I’m going to reprint a crucial discussion from a piece published in these pages years ago.

The overarching point is that in a world where conspiracy theories run rampant and largely unchecked, the idea that central bank liquidity boosts the prices of financial assets ain’t one of them – so to speak.

And if you think it is, then perhaps you should consult with Ben Bernanke who, in 2010, told The Washington Post that, quote, “this approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action”.

Before I leave you with a series of great passages from a previous exposition, let me remind you that this is also a criticism of those who, on social media, say things like “They’re at it again!” or “They’re not even trying to hide it!“, regarding central banks and financial assets. Those folks are correct. “They” are not “trying to hide it”, precisely because there isn’t anything to hide. This is, quite literally, the mechanism by which QE works.

From ‘After A Decade’, originally published July, 2018

One of the most interesting things about the post-crisis monetary policy regime is that for the longest time, pundits and Johnny-come-latelies to the asset management industry attempted to suggest that the inexorable rise in prices for risk assets was somehow not a function of central bank accommodation and that anyone who suggested it might be was a “conspiracy theorist.” That’s not a strawman. I can give you countless examples of people who have accused anyone that cites QE as the proximate cause for the risk rally as pushing the market equivalent of an Area 51 narrative.

If you ask me, the years-long tendency for some market participants to deny reality stemmed in part from an unwillingness to accept the fact that gains logged since 2009 weren’t generally the result of a prudent decision to “be greedy when others are fearful” (to employ that nebulous Buffett quote). Rather, those gains were in large part attributable to G4 central banks deliberately inflating asset prices in an effort to reflate the global economy.

The tendency for folks to deny that (and those denials usually took the form of someone posting a chart of earnings growth overlaid with the S&P and slapping a sarcastic caption on it about how the “fundamentals” are what matters, not quantitative easing), was bizarre for a number of reasons, not the least of which can be expressed as a question: Who cares what’s behind those triple-digit gains on your screen? That is, the gains might be “artificial” in the sense that they aren’t attributable to your own investing acumen, but they are very “real” in the sense that if you decide to realize them, you can spend that money.

Additionally, accommodative policy was designed to help improve the fundamentals, so it’s not exactly a coincidence that fundamentals improved in lockstep with the growth of central bank balance sheets.

Beyond that, there is nothing “conspiratorial” about central bank easing.

There has of course been an ongoing, coordinated effort by developed market central banks to inflate the prices of risk assets since the crisis. As I never tire of reminding you, that is the furthest thing from a conspiracy imaginable. It’s how QE works, and for anyone who was unfamiliar with the mechanics, it was explained very explicitly in a 2010 Op-Ed in The Washington Post by Ben Bernanke called “What The Fed Did And Why.” That Op-Ed contains this passage:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

If central banks driving stock prices higher and deliberately suppressing corporate borrowing costs is a “conspiracy theory”, well then Ben Bernanke is a “conspiracy theorist”.

And if, to take the other side of the argument, this was supposed to be some kind of a closely-held secret that only central bankers knew about, well then Ben Bernanke is the worst co-conspirator in the world. I don’t know about you, but I don’t want to be in a “conspiracy” with a guy who writes an Op-Ed for The Washington Post called “What We Did And Why.”

The point is, “yes” there has been an ongoing effort on the part of central banks to inflate stock prices and catalyze a global hunt for yield that ends up driving everyone down the quality ladder and out the risk curve, with the effect of leaving everything priced to perfection in fixed income.

But “no”, that is not a conspiracy. Again, it’s literally how accommodative policy works.

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