The Fed helped revive stocks, but its actions created new risks – Minneapolis Star Tribune

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Whatever it takes. That’s the unofficial policy the Federal Reserve has adopted in its mission to save the U.S. economy from the coronavirus. It’s also (by far) the biggest reason why stock prices have rallied more than 50% in less than six months.

To be sure, it’s appropriate that equities have responded positively to the largest batch of monetary stimulus in history. To put the Fed’s 2020 stimulus in perspective, it bought more bonds in one week in April ($625 billion) than in the entire eight-month QE2 phase in 2010-11. Some estimates suggest the Fed’s total balance sheet will reach $9 trillion-$10 trillion in assets by the time its pandemic-response measures are complete, roughly triple what it was a year ago.

If the Fed pulled out its bazooka to battle the Great Recession, it’s using tomahawk missiles against COVID-19. Massive liquidity injections and asset-buying have changed the formula investors use to value securities. That helps explain why the S&P 500 has become so disconnected from the underlying economic conditions.

Higher stock and bond prices are the most obvious result of historic Fed policy, but those benefits also create new risks. With only one relative precedent for a global pandemic (1918) and no precedent for deficit spending on this scale, traditional valuation methods seem less relevant than ever.

The S&P 500’s forward price-to-earnings (P/E) ratio is approaching 23. That’s a 50% premium to its average P/E over the last decade. U.S. market capitalization relative to GDP (180%) has never been so elevated. Equities, in other words, are setting all-time highs based more on sentiment than on fundamentals.

The danger is that when optimism fades, there will be less structural support to slow the fall. We saw evidence of this in early September when the Nasdaq fell 10% in just three trading days despite very little news. While Fed intervention should mitigate the odds of another 35% collapse, investors should expect larger daily swings in stock prices will remain the norm.

Current Fed policy also discourages diversification. Of the three traditional asset classes (stocks, bonds and cash), two of them appear especially unattractive thanks to historically low interest rates. When the dividend yield of the S&P 500 (1.85%) is two-and-a-half times greater than the 10-year Treasury yield (0.72%), it’s hard to get excited about bonds. As a result, many investors have shifted toward more aggressive portfolios despite the risks. Cash, meanwhile, yields even less and is vulnerable to our next point of discussion.

Inflation was inevitable, but the Fed has accelerated its arrival. This might seem counterintuitive with the Fed Funds rate near zero, but unlimited money-printing has led to a weaker U.S. dollar. That means more dollars are required to purchase foreign goods, which contributes to inflation. The Fed last month also adjusted its official policy targets to allow for periods of higher inflation in order to spur job growth. And let’s not forget inflation will ease the burden of the largest-ever U.S. government debt.

The Fed has rescued financial markets, and while its policies have also encouraged some irrational behavior, these market conditions will likely persist until long after the economy recovers. Investors need to be mindful of the different risks we face in this new environment.

Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be reached at ben.marks@marksgroup.com. Brett Angel is a senior wealth adviser at the firm.

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