New York Fed Sees Five More Years Of Stock Increases

Tyler Durden's picture

Normally the New York Fed would not have to bother itself with such Series 7, 63-registration requiring, "financial advisor"-type things as predicting where the stock market will go, especially when it is its own trading desk that provides the impetus for more than 100% of the current equity rally. However, these are not normal times - they are New Normal. And as a result, Fed economists Fernando Duarte and Carlo Rosa have penned a "research" paper titled "Are Stocks Cheap?" in which they view the same reflexive "evidence" that Ben Bernanke himself used to answer a question during a recent press conference if he would still be buying stocks at record levels, namely the risk premium. This is what the NYFed's economists say on the matter: "We surveyed banks, we combed the academic literature, we asked economists at central banks. It turns out that most of their models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years."

They find, not surprisingly, that based on various economist models, the risk premium has never been higher.

As a reminder, the equity risk premium is "expected future return of stocks minus the risk-free rate over some investment horizon." It is this record high risk premium that leads the two to agree with Wall Street and to forecast that stocks have nothing but upside for half a decade more. Of course, what they try to not highlight is that the previous near all time high equity risk premium was seen in the days just before the Lehman collapse, when the same poll and the same models, would have predicted smooth sailing for a long, long time, instead of the 60% modest correction that transpired in the coming months, and which would have led to the end of the Western financial model as we know it if not for the same NY Fed injecting a little over $10 trillion into risk on short notice. But don't worry, there is an economist "explanation" for this particular fly in the ointment: "It is difficult to argue that we’re living in rosy times, but we are surely in better shape now than then."

Surely.

So assuming one buys into the explanation that this time it's different and "we are in better shape now than then" (even if said shape is purely due to the trillions in excess liquidity injected by the world's central banks over the past five years, something which is completely ignored by the very same Fed's economists), here is how an economists goes about justifying an equity valuation:

Why is the equity premium so high right now? And why is it high at all horizons? There are two possible reasons: low discount rates (that is, low Treasury yields) and/or high current or future expected dividends. We can figure out which factor is more important by comparing the twenty-nine models with one another. This strategy works because some models emphasize changes in dividends, while others emphasize changes in risk-free rates. We find that the equity risk premium is high mainly due to exceptionally low Treasury yields at all foreseeable horizons. In contrast, the current level of dividends is roughly at its historical average and future dividends are expected to grow only modestly above average in the coming years.

 

In the next chart we show, in an admittedly crude way, the impact that low Treasury yields have on the equity risk premium. The blue and black lines reproduce the lines from the previous chart: the blue is today’s equity risk premium at different horizons and the black is the average over the last fifty years. The new purple line is a counterfactual: it shows what the equity premium would be today if nominal Treasury yields were at their average historical levels instead of their current low levels. The figure makes clear that exceptionally low yields are more than enough to justify a risk premium that is highly elevated by historical standards.

 

Keep the above bolded, underlined sentence in mind for a second.

So let's fast forward to the authors' summary:

At face value, this result means that the models are actually helpful in forecasting returns. However, we should keep in mind some of the limitations of our analysis. First, we have not shown confidence intervals or error bars. In practice, those are quite large, so even if we could have earned extra returns by using the models, it may have been solely due to luck. Second, we have selected models that have performed well in the past, so there is some selection bias. And of course, past performance is no guarantee of future performance.

Actually, at "face value" the models have been horribly wrong at forecasting returns especially in situations in which confidence in the entire system collapses, and as a result five years later, the Fed, and all its central bank peers, are forced to inject more and more liquidity to keep the house of cards: both the market and the economy from imploding.

Which actually is also the biggest failing of the paper.

Let's go back to the bolded sentence above:

"The new purple line is a counterfactual: it shows what the equity premium would be today if nominal Treasury yields were at their average historical levels instead of their current low levels."

Looking at the chart shows that the Risk Premium would be negative in a "normal" environment - or one where bonds were back at their historical averages, where even the Fed, not to mention Congress and the President, see them reverting to one day when the Fed supposedly exits the market.  And what is most stunning about this entire paper authored by Fed economists, is that the authors completely ignore that the only reason the Treasury yields are low is because of the Fed's distortions of the bond market itself. In other words, nobody at the Fed has even the faintest understanding of recursive, circular logic, or what Soros famously pegged as reflexivity.

Which in turn means that the longer one chases stocks relative to a baseline "normal" risk free rate, the more negative the premium would be, and the greater the stock market fall, once things are allowed to normalize (if ever).

Perhaps, instead of coming up with this sad attempt at pitching stocks, the NY Fed were to come up with something relevant like where the 10 Year bond would be not only if the Fed was out of the market, but if it had never entered, the general public would have a sense of just how massively overvalued stocks truly are when factoring out the biggest artificial component to the "rally", and also why, intuitively, virtually everyone hates what has become a daily no volume levitation on nothing but the expectation that i) the Fed will continue the liquidity tsunami indefinitely and ii) the Fed will not lose control of the market and the economy, as it did in 2008.

Is it any wonder why the occupation "economist" (not really a job, more of a clerical position) and especially one with a political bent, sent here from above to justify an ever-encroaching government, and a ruinous central planning regime that only serves to perpetuate capital misallocation and wealth transfer from the middle to the upper class, has become the most pejorative "four letter" word in existence?