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The Fed’s ‘Wizard of Oz’ Effect on the S&P 500: GMO

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The Federal Reserve’s influence on the stock market has become “particularly pronounced since the onset of its unconventional policies,” according to a new white paper by James Montier and Philip Pilkington of GMO’s asset allocation team.

The pair examine the effect the “Wizard-of-Oz-like nature of the Fed” on the S&P 500 on days when the Federal Open Market Committee has a meeting.

The idea for Montier and Pilkington’s study actually stemmed from research from the Fed itself.

The pair point to research from the New York Federal Reserve – a paper published in 2013 called “The Pre-FOMC Announcement Drift” – that finds “large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the FOMC in the past few decades.”

So, Montier and Pilkington decided to do their own study. Rather than using tick data as the Fed researchers did, the pair used full-day data and found they reached a similar conclusion.

They found that sometime around 1985, the market really started to react to FOMC days.

“Like the Fed economists, we found that for the past 30 or so years these announcement days have had a major, and increasing, impact on the stock market,” the pair write in the report.

According to the GMO report, FOMC days account for 25% of the total real returns since 1984.

“One of our bright young colleagues, who is considerably more statistically sophisticated than we, calculated that the chance of this occurring randomly was only 0.0086% (that is, 86 out of 1 million),” Montier and Pilkington write in the report. “As he put it, ‘The odds are astoundingly low!’”

According to the GMO report, beginning in the early 1980s, returns were substantially higher on FOMC days than they were on the average day. And, the period between 2008 and 2012 is particularly notable.

“Average returns on FOMC days in this period [2008-2012] were phenomenally high; some 29x higher than on the average day, testimony to the impact of QE and ‘unconventional monetary policy’ upon the market’s behavior,” the pair write in the report. “More recently, the impact the Fed is having on the market has shrunk back to its ‘normal’ post-1980s level accordingly. Evidence of QE fatigue perhaps?”

Montier and Pilkington then looked to see whether the type of action the Fed took had any impact on returns. To do this, they used data from 1990 onward and broke down the FOMC days into those where the Fed increased or decreased rates or simply left them unchanged. Regardless of the Fed’s action, the pair find that there were huge moves on every FOMC day.

“This evidence would seem to suggest that ‘easing’ wasn’t driving the returns to FOMC days,” the report states.

According to the report, there was no difference statistically speaking in the returns to days when the Fed raised or cut interest rates.

“In essence it appears that the stock market reaction wasn’t driven by easing so much as it was by the fact that the FOMC was meeting at all!” write Montier and Pilkington.

What would the S&P 500’s valuation look like if the Fed didn’t have any impact on the behavior of investors?

Montier and Pilkington modified Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE) in order to gauge the impact the Federal Reserve policies have been having on the S&P 500.

The pair looked at the returns for the S&P 500 and replaced the days when the FOMC met with the average return on non-FOMC days.

What they found is that if they removed the impact of the FOMC days, the CAPE was significantly more mean-reverting than it has been over the last 20 years or so.

“The tech bubble would not have gotten quite so big (although it would still have been the biggest stock market bubble in U.S. history) without the Fed’s help; in the wake of the [global financial crisis] the market would probably have gotten down to the levels of valuation associated with a serious crisis (i.e., single-digit P/Es).”

After the financial crisis in particular, the Fed has affected the valuation of the stock market significantly and prevented “mean reversion to occur in the fashion that we would have expected,” according to Montier and Pilkington.

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