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Chart Of The Year: The Fed Has Doubled The S&P Admits... The Fed

Submitted by Tyler Durden on 07/11/2012 08:56 -0400

Prepare to have your minds blown courtesy of what is easily the most astounding chart we have seen in a long, long time, prepared by the economists at the, drumroll, New York Fed, which finds that absent what the Fed calls "Pre-FOMC Announcement Drift", or the move in the S&P in the 24 hours preceding FOMC announcements, the S&P 500 would be at or below 600 points, compared to its current level over 1300. The reason for the divergence: the combined impact of cumulative returns of in the S&P on days before, of, and after FOMC announcements. But, but, fundamental, technical, coffee grinds, Finance 101, Oprah Winfrey, Jim Cramer and Econ 101 analysis (in declining order of relevance and increasing order of voodoo) all tell us this is im-po-ssible? Because if the Fed is right about the Fed induced drift, it is all about, you guessed it, easy money.

Here it is, black pixels on white LCD, straight from Simon "Harry" Potter henchmen's mouth:

We show that since 1994, more than 80 percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements (which occur only eight times a year)—a phenomenon we call the pre-FOMC announcement “drift.”

We are fairly certain one can come up with many other names for this "phenomenon." It goes on:

Our findings suggest that the pre-FOMC announcement drift may be key to understanding the equity premium puzzle since 1994. However, at this point, the drift remains a puzzle.

Not a puzzle. Just go into sub-basement C and keep staring at the Heidelberg Mainstream 80, Web-fed Rotary Printer until the puzzle solves itself.

Full paper:

The Puzzling Pre-FOMC Announcement “Drift”

David Lucca and Emanuel Moench

For many years, economists have struggled to explain the “equity premium puzzle”—the fact that the average return on stocks is larger than what would be expected to compensate for their riskiness. In this post, which draws on our recent New York Fed staff report, we deepen the puzzle further. We show that since 1994, more than 80 percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements (which occur only eight times a year)—a phenomenon we call the pre-FOMC announcement “drift.”

The equity premium is usually measured as the difference between the average return on the stock market and the yield on short-term government bonds. Previous research on the size of the premium finds that it is too large for plausible levels of risk aversion (see Mehra [2008] for a review).

The Drift: A First Take

The pre-FOMC announcement drift is best summarized in the chart below, which provides two main takeaways:

Since 1994, there has been a large and statistically significant excess return on equities on days of scheduled FOMC announcements.

This return is earned ahead of the announcement, so it is not related to the immediate realization of monetary policy actions.

The chart shows average cumulative returns on the S&P 500 stock market index over different three-day windows. The solid black line displays the average cumulative return starting at the market’s opening on the day before each scheduled FOMC announcement to the market’s close on the day after each announcement. Our sample period starts in 1994, when the Federal Reserve began announcing its target for the federal funds rate regularly at around 2:15 p.m., and ends in 2011. (For a list of announcement dates, see the FOMC calendars.) The shaded blue area displays the 95 percent confidence intervals around the average cumulative returns—a measure of statistical uncertainty around the average return. We see from the chart that equity valuations tend to rise in the afternoon of the day before FOMC announcements and rise even more sharply on the morning of FOMC announcement days. The vertical red line indicates 2:15 p.m. Eastern time (ET), which is when the FOMC statement is typically released. Following the announcement, equity prices may fluctuate widely, but on balance, they end the day at about their 2 p.m. level, 50 basis points higher than when the market opened on the day before the FOMC announcement.

How do these returns compare with returns on all other days over the sample period? The dashed black line, which represents the average cumulative return over all other three-day windows, shows that returns hover around zero. This implies that since 1994, returns are essentially flat if the three-day windows around scheduled FOMC announcement days are excluded.

A Deeper Look through Regression Analysis

The previous chart showed stock returns without accounting for dividends or the return on riskless alternative investments. In the table below, we account for these factors in a regression analysis by considering the return, including dividends (in percent), on the S&P 500 index in excess of the daily yield on a one-month Treasury bill rate, which is a measure of a risk-free rate. We regress this “excess return” on a constant and on a “dummy” variable, equal to 1 on days of FOMC announcements.

The coefficient on the constant (second row) measures the average return on non-FOMC days, while the coefficient on the FOMC dummy (top row) is the differential mean return on FOMC days. In the first column, we regress close-to-close stock returns and see that excess returns on FOMC days average about 33 basis points, compared with an average excess return of about 1 basis point on all other days. As seen in the previous chart, this return is essentially earned ahead of the announcement—hence our label of a pre-FOMC announcement drift. Indeed, in the third column we see a return of about 49 basis points during a

2 p.m.-to-2 p.m. window, while the FOMC releases its statement at 2:15 p.m. ET. In the second column, we repeat the regression using the close-to-close returns from 1970 to 1993, which is prior to when the Fed released its policy decisions right after each meeting, and see that essentially no such premium exists. The bottom rows of the table decompose the annual excess return of the S&P 500 index over Treasury bills on the return earned on FOMC days and the return earned on all other days. As shown in the third column, the return on the twenty-four-hour period ahead of the FOMC announcement cumulated to about 3.9 percent per year, compared with only about 90 basis points on all other days. In other words, more than 80 percent of the annual equity premium has been earned over the twenty-four hours preceding scheduled FOMC announcements, which occur only eight times per year.

The chart below visualizes this return decomposition. It shows the S&P 500 index level along with an S&P 500 index that one would have obtained when excluding from the sample returns on all 2 p.m.-to-2 p.m. windows ahead of scheduled FOMC announcements. In a nutshell, the figure shows that in the sample period the bulk of the rise in U.S. stock prices has been earned in the twenty-four hours preceding scheduled U.S. monetary policy announcements.

An International Perspective
Does this striking result apply only to U.S. stocks? While we do not find similar responses of major international stock indexes ahead of their respective central bank monetary policy announcements, we observe that several indexes do display a pre-FOMC announcement drift, as the chart below shows. Cumulative returns rise for the British FTSE 100, German DAX, French CAC 40, Swiss SMI, Spanish IBEX, and Canadian TSE index when each exchange is open for trading over windows of time around each FOMC announcement in our sample.

Potential Explanations

One might expect similar patterns to be evident also in other major asset classes, such as short-and long-term fixed-income instruments and exchange rates. Surprisingly, though, we don’t find any differential returns for these assets on FOMC days compared with other days. In other words, the pre-FOMC drift is restricted to equities. Further, we don’t find analogous drifts ahead of other macroeconomic news releases, such as the employment report, GDP and initial claims, among many others. The effect is therefore restricted to FOMC, rather than other macroeconomic, announcements. In the Staff Report, we attempt to account for standard measures considered in the economic literature that proxy for different sources of risk, such as volatility and liquidity, but they also fail to explain the return. Finally, we consider alternative theories that feature political risk, investors with capacity constraints in processing information, as well as models where stock market participation varies over time. Although these theories can help qualitatively explain the existence of a price drift ahead of FOMC announcements, they are counterfactual in some dimension of the empirical evidence.

Our findings suggest that the pre-FOMC announcement drift may be key to understanding the equity premium puzzle since 1994. However, at this point, the drift remains a puzzle.

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Wed, 07/11/2012 - 11:07 | 2606082 Dareconomics

This gist of this post is that the Fed's action has distorted the stock market. Most of the action occurs in the time around FOMC releases. Now, we have to sort out the cause and effect. What ZH is stating is that if we take out the FOMC periods the market is basically flat since 1994. I think this information is actually more insidious than it looks. To me it appears that the financial firms figured out this play a long time ago and they save their buying for these days; hence, Fed action is a self-fulfilling prophecy.

When I quit smoking a few years ago, I began drinking coffee in the morning. After awhile a pattern developed. A few minutes after I finished my cup, I would go to the bathroom. Things have changed over the years. At first I no longer had to drink the coffee to go the bathroom. Merely smelling the coffee as the machine brewed was enough. Nowadays, turning the machine on does the trick as my body has been conditioned over the years to anticipate the effects of the caffeine.

This is how Fed stimulus works. Way back, the money would actually have to work its way into the system to achieve the desired effect. Today, a lower threshold for results is in play. As the market is conditioned to expect a stimulus. Like me, one day it will take a big shit.

Wed, 07/11/2012 - 11:13 | 2606094 falak pema

Here is some puzzling news published by the European Banking agency :

Les banques françaises ont atteint le niveau de capitaux requis

It pretends that ALL four major french banks have achieved the June 30 target of upgrading their COre first tier equity to over the 9% hurdle.

It would be nice to hear RM on this!

Wed, 07/11/2012 - 11:09 | 2606100 monopoly

What a sick market. I wish it would all just implode already so we can start over. I know, keep dreaming. Not gonna happen anytime soon.

Wed, 07/11/2012 - 11:12 | 2606109 boiltherich

You know once upon a time in America it was seriously illegal to manipulate markets or to profit from information you have access to that is not public. Some of you might even be old enough to remember that. Anybody who would buy, sell, or trade in markets as completely corrupted as our financial markets really has no place to bitch and whine when they get burned by those markets.

Wed, 07/11/2012 - 11:15 | 2606118 Alpacanio

Hell, i'm lining up to buy a Nimitz class Aircraft Carrier when this all blow up.

Wed, 07/11/2012 - 18:30 | 2608084 HungrySeagull

Gonna cost you a cool bil or so to pay the crew to run it each week.

But in the era of american large cars, this money pit would fit right in.

Wed, 07/11/2012 - 11:34 | 2606193 cdskiller

Jaw on the ground stuff, and yet completely predictable. "since 1994, returns are essentially flat"

Why did this begin in 1994? That's what isn't addressed. Certainly, the incentive to rig markets in this way was present before then, say, since the beginning of time, but in this country and then, of course, the world, which takes our investment lead, something changed around 1994 in financial markets. What was the particular practice that changed? The holy grail for bank and non-bank institutional investors has always been to create a permanent disconnect between the ups and downs of the economy as a whole, of the rise and fall of the stock market or of real estate prices and, thereby, the assets of the average investor, and the ability of institutional investors to guarantee their own profits. They wanted our capital to be theirs and theirs, alone.

What happened was a coordinated drive to institutionalize the freedom to create forms of investment insurance, available only to institutional investors. This practice first led to the S & L crisis and lessons should have been learned from that crude form of fraud. And they were. The discovery of a Nobel Prize-winning pricing model for futures and options created the opportunity for a new casino where hedging against collapse could become the biggest secret casino the world has ever seen. When the model proved to be disastrously fraudulent, as demonstrated by the collapse of LTCM, again, lessons should have been learned. And they were. The investment community went all in, bribing legislators to keep out, banking on their ability to predate on less sophisticated investors globally. The model was institutionalized, regulations of the OTC futures and options market were prevented and banks and hedge funds grew into behemoths and total control over our governments could be implemented.

Futures and options are the cancer. The OTC derivatives market must be killed or they will destroy us.

Wed, 07/11/2012 - 12:10 | 2606337 pashley1411