There’s a popular narrative in the stock market that it was the Federal Reserve – and not much else – that powered the strong stock market returns in the decade following the 2008 Global Financial Crisis. The thinking goes that because the Federal Reserve kept interest rates at the zero bound for years following the 2008 financial meltdown (and again following the pandemic), and because the central bank expanded their balance sheet with quantitative easing measures over the same period (see chart below), investors were ‘basically forced’ to flood into risk assets.1
The Fed’s Balance Sheet – Expands in 2008, Soars in 2020
I’m not saying this line of thinking is wrong. Easy money no doubt supercharged capital flows into stocks and other risk assets. Investors in search of yield had limited options in the bond markets, and massive amounts of liquidity meant more money was sloshing around in the capital markets. Much of it made its way into stocks.
What gets left out of this narrative, however, is any role that rising corporate earnings may have played in the stock market’s ascent. That’s where I take issue. Aggregate S&P 500 earnings-per-share grew steadily from 2009 to 2015, contracted slightly, and then trended sharply higher up until the end of 2019. Aggregate EPS for S&P 500 companies more than doubled in this period, with profit margins reaching their highest point in decades by 2022. Zooming out even further, we know that year-over-year operating EPS growth averaged 8.4% from 2001 to 20223, which is almost perfectly in-line with the S&P 500’s 8.71% annualized return over that same period.4 In short, stocks were propelled by much more than just the Fed.
I think a better way to frame the Fed’s easy money impact on the stock market is to view it in terms of market return (beta) versus excess return (alpha).
I’ve made the argument above that the Fed’s easy money policies – combined with many years of steady earnings and economic growth – have been driving the stock market higher since 2008. Valuations were low when the Fed engaged in aggressive monetary easing, which became a ‘rising tide that lifted all boats’ in the stock market. Beta ruled, and the differentiation between individual stocks was lower than average. Investors did not need to do much beyond owning a broad set of stocks in order to do well. In other words, high beta delivered – the average annual return for the S&P 500 was 15% from 2010 to 2021.
Looking ahead, tighter money (chart below) may mean lower beta, which sets the stage for alpha to play a bigger role in portfolio returns going forward.
Year-over-year % change in Fed’s Balance Sheet
Bottom Line for Investors
In the decade following the Global Financial Crisis, the Fed’s main objective was to support economic growth. Inflation was an afterthought.
The current environment is, of course, just the opposite. With the Fed making decisions almost unilaterally focused on inflation, they are likely to be less supportive of growth – which may factor as a headwind for risk assets. What’s more, valuations are currently at relatively high levels, which means the starting point for tighter monetary conditions is one where stocks aren’t cheap.
Given this setup and looking out over the next decade, investors should not expect the same 15% annualized returns stocks experienced from 2010 to 2021. Lower beta does not necessarily have to mean lower portfolio returns, however. It just means investors and managers will likely need to generate more alpha in portfolios, which plays nicely into a central tenet of our investment approach here at Zacks.
1 Black Rock. July 28, 2023. https://www.blackrock.com/us/individual/insights/equity-investing-for-a-new-era
2 Fred Economic Data. September 7, 2023. https://fred.stlouisfed.org/series/WALCL#
3 J.P. Morgan. August 31, 2023. https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/?gclid=Cj0KCQjwmICoBhDxARIsABXkXlKEwzu1pOK4ldrG0WzcPVDn1jeam7dSUKFu_7tFO9SbwNAwzFwb9aMaArH1EALw_wcB&gclsrc=aw.ds
5 Fred Economic Data. September 7, 2023. https://fred.stlouisfed.org/series/WALCL#
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