Wall Street boom or bubble? Don't blame it all on the Fed

WALL Street is screeching to yet another all-time high, just as the Fed's Jackson Hole symposium is set to address wealth inequality and the central bank's role in fuelling asset price inflation is once again coming under harsh scrutiny.

It is undeniable that trillions of dollars of asset purchases and years of official interest rates of zero and 10-year bond yields barely above one per cent have boosted stock prices. But the significance of Fed actions are overstated.

The tech-heavy composition of Wall Street, which benefits more from low interest rates and plain old stronger economic growth, is adding fuel to the US stock surge. And the Fed's large balance sheet expansion is nowhere near the European Central Bank or Bank of Japan's.

Look no further than Wall Street: The S&P 500 has more than doubled from its Covid low of March last year, chalking up 51 record highs this year.

According to Ryan Detrick, chief market strategist at LPL Financial in Charlotte, North Carolina, only 1964 and 1995 had more than 50 new highs by the end of August. He reckons the S&P 500 could make 78 new highs this year, eclipsing the all-time record of 77 set in 1995. On a 12-month forward earnings valuation basis, the S&P 500 earlier this year was its most expensive since 1999, just before the tech bubble burst. This price/earnings ratio has since drifted lower. But it is still above 20, which is unfamiliar territory for most of the last two decades.

Official interest rates and ultra-low benchmark bond yields make investing in profitable, cash-generating companies an attractive proposition. To some investors desperate for return, riskier stocks are a no-brainer. Many argue there is a natural consequence of the Fed doubling the size of its balance sheet to US$8.3 trillion since the pandemic outbreak. As a share of GDP, that is now around 40 per cent.

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With stocks and other financial assets mostly in the hands of society's better off, critics say US monetary policy is widening the gap between rich and poor and directly exacerbating wealth inequality.

The world's second and third largest central banks, meanwhile, have also ramped up their pandemic-fighting asset purchases. Their balance sheets, as a share of GDP, are far bigger than the Fed's. Yet stock markets and valuations in the eurozone and Japan are nowhere near as high.

"The commonly held narrative centres on the Fed, and if everyone believes that, then it is self-reinforcing," said Meb Faber, co-founder and chief investment officer at Cambria Investments in El Segundo, California. "But there is a limit as to how far you can extrapolate that."

The ECB has grown its balance sheet to US$9.5 trillion since the outbreak of the pandemic. The ECB's balance sheet is now worth more than 60 per cent of eurozone GDP.

Similarly, the Bank of Japan has grown its balance sheet by US$1.4 trillion since March 2020 to US$6.6 trillion, around 120 per cent of GDP.

Yet the euro Stoxx 50 is up "only" around 65 per cent from the Covid low, and is still 23 per cent below its record high from March 2000. Euro stocks' 12-month forward price/earnings ratio is around 16.

Japan's Topix is up 55 per cent from the Covid low and has a forward multiple of around 13.

Both figures, again, are significantly below their US equivalents, suggesting factors other than central bank largesse are behind Wall Street's surge. For one, the US equity market is far more tech- and digital-heavy than its global peers.

A world of zero interest rates benefits tech companies disproportionately because a low discount rate inflates future cash flows for companies where cutting edge innovation is likely to fuel faster growth. By any measure, the big five tech 'FAANG' stocks - Facebook, Amazon, Apple, Netflix and Google - dominate Wall Street. They have risen more than three times the broader S&P 500 in the last five years and their US$7 trillion market cap is 21 per cent of the whole index.

Another is good old-fashioned economic growth. Some of the more bullish US forecasts have been trimmed recently, but the International Monetary Fund expects 7 per cent GDP growth in the US this year, 4.6 per cent in the eurozone, and just 2.8 per cent in Japan.

On top of that, Corporate America is motoring along nicely. LPL Financial's Mr Detrick notes that some 85 per cent of S&P 500 companies posted second quarter earnings that beat estimates. And 2021 consensus earnings per share estimates are for a 43 per cent jump from last year. "The Fed backstop helps explain why people are willing to pay higher multiples. Investors still see better opportunity in the US, and are willing to pay that premium," he said. REUTERS