The Federal Reserve building in Washington.
Chip Somodevilla/Getty ImagesA new study shows conclusively that the so-called Fed put really exists. But that doesn’t mean stock market bulls can stop worrying about a bear market.
I’m referring, of course, to the Federal Reserve’s supposed commitment to ease monetary policy whenever the stock market suffers significant losses. Analysts have been speculating about its existence at least since early 2000, when mentions of a Fed put began to regularly appear in the financial press. It has never been articulated as official Fed policy, however, and some have doubted that it even exists.
The new research that proves otherwise is forthcoming in the Review of Financial Studies. Entitled “The Economics of the Fed Put,” its authors are Anna Cieslak, a finance professor at Duke University’s Fuqua School of Business, and Annette Vissing-Jorgensen, a finance professor at the University of California, Berkeley’s Haas School of Business.
The professors found compelling evidence of the Fed put’s existence back to the mid-1990s. They exhaustively analyzed decades’ worth of minutes and transcripts of meetings of the Federal Open Market Committee, the stock market’s performance between those meetings, and the federal-funds rate—the target rate the FOMC sets and at which commercial banks lend and borrow to each other overnight.
One way of appreciating their findings is to focus on the econometric model they constructed, based on historical data, for predicting how the FOMC will react to a stock-market decline between meetings. According to the model, a 10% decline in the stock market will be followed by 32-basis-point cut at the next FOMC meeting. (A basis point is 1/100th of a percentage point.)
The professors tested this model against dozens of alternative indicators of economic activity. They found it to better predict the FOMC’s behavior than any of the 38 macroeconomic indicators available in Bloomberg’s economic calendar or the 85 indicators that make up the Chicago Fed National Activity Index.
The professors completed their study before this year, so their model faced a real-time test in the wake of the stock market’s waterfall decline in February and March. From peak to trough the S&P 500 fell 34%, implying that the fed-funds rate would subsequently fall by 109 basis points. The actual reduction was 150 basis points. In the messy world of economic forecasting, that prediction has to be judged a success.
Note carefully that the professors didn’t find that stock-market strength leads to a corresponding increase in the fed-funds rate. The only correlation they found was between stock market weakness and a reduction in the rate.
Investment Implications
Does this evidence of a Fed put mean that stock-market bulls can breathe more easily, now fully confident that the central bank will bail them out if equities decline? Not necessarily. That’s because of a potentially ironic aspect of the Fed put: It may be fully effective in the future only to the extent investors don’t expect it to be exercised.
This appears to have been the case over the past 2½ decades, Cieslak said in an interview. “My research shows that a large part of [the Fed’s easing] following stock market declines over the last [2½] decades came as a surprise to investors,” she says.
This implies that the success of the Fed put depends at least in part on investors being surprised. If investors were to have advance knowledge of how the FOMC would react, then its actions would already be reflected in stock prices. That in turn would mean that when the stock market does decline, as it inevitably will do on occasion, the Fed’s reactions at that time will have no additional effect on equity prices.
Another way of putting this, according to Cieslak: The FOMC has to beat expectations in order for the Fed put to counter stock-market declines. And that’s why the Fed’s job could get increasingly difficult as more investors become aware of the Fed put’s existence.
This appears already to be happening, in fact. Investors in March of this year were very aware of the magnitude of the Fed’s monetary stimulus in 2008, and undoubtedly some were expecting something similar. To surprise the market, therefore, the Fed needed to do something even more aggressive. And that’s what it indeed did, increasing the Fed’s balance sheet by $3 trillion, compared with “just” $1 trillion in 2008.
To bet that the Fed put constitutes a safety net on your equity portfolio in the future, therefore, you have to bet that the Fed will continually be able to beat investor expectations. But how long can the Fed continue to do so if investors’ expectations keep rising, especially now with documentation that the Fed put exists?
Put this way, the bet seems like less of a sure thing.
The Fed Put and the Value Premium
This new study also casts doubt on an argument value investors have used to excuse value stocks’ recent poor performance.
Value stocks, of course, are those that are trading for low prices relative to measures of net worth, such as book value. Growth stocks are those that feature higher such ratios. For most of the past century, value stocks have significantly outperformed growth stocks, on average, but this value premium has been negative on balance for more than a decade.
Many analysts have blamed this poor performance on the Fed put, arguing that the Fed’s actions have reduced the downside risks that growth stocks otherwise would face to a greater degree than value stocks.
Plausible as this argument otherwise is, it’s hard to square with the study’s findings that the Fed put has existed since 1994. The intervening 26 years include one of the strongest multiyear stretches of value beating growth in U.S. history. I’m referring to the period between the market high at the top of the dot-com bubble in March 2000 and the bear market low in the fall of 2002.
Despite the existence of the Fed put over that 2½-year period, value beat growth by more than over any other period of similar length since at least the mid-1920s, according to data from Dartmouth College finance professor Ken French.
Value stocks have been looking better recently, especially since the presidential election, raising hopes among long-suffering value investors that the market is entering another period like the one between 2000 and 2002. This new study shows that this hope is not dependent on the Fed put going away.
Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
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