The Fed issues a warning about the stock market

My Comments: Here’s #5 in this weeks theme of what to do with money burning a hole in your investable cash pocket. One would think the Chairman of the Federal Reserve would have a pretty strong grasp of economics and the world of money. That makes him a legitimate source of how things might play out going forward. Hopefully, he doesn’t have any political axes to grind that would color his thinking. We can at least hope so.

by Sam Ro \ 18 MAY 2020 \

We’ve been hearing a lot from Chairman Jay Powell and his colleagues on the Federal Open Market Committee.

Powell himself spoke last Wednesday on a webinar for the Peterson Institute for International Economics. Last night, he appeared before America on CBS’s “60 Minutes.”

This week, Powell is testifying on the CARES Act on Tuesday before the Senate Banking Committee; on Thursday he’ll give the opening remarks at a “Fed Listens” event on COVID-19.

These frequent appearances suggest, among other things, that the Fed doesn’t want people to misunderstand what it’s doing from a policy perspective. And that its communication is an important part of hammering home what its policies are designed to do and not to do.

In its latest biannual Financial Stability Report published Friday, the Fed aims, among other things, to make clear that when you put money into the market, you risk losing that money. There is no explicit Fed backstop in the equity market.

“Asset prices remain vulnerable to significant declines should the pandemic worsen, the economic fallout prove more adverse, or financial system strains re-emerge,” the Fed said in its report.

“Equity prices plunged as concern over the COVID-19 outbreak grew, reflecting declines in both investor appetite for risk and expected income,” the Fed added.

“Equity prices relative to forecasts of corporate earnings also declined below the historical median. However, prices relative to earnings forecasts have risen since late March to levels seen before the outbreak: Prices have increased a fair bit from their trough, and analysts’ firm-level earnings forecasts have fallen in response to the economic deterioration.”

Indeed, price/earnings ratios briefly appeared to be cheap before quickly returning to historic highs.

In its report, the Fed also noted that the equity risk premium — the premium investors demand from equities over risk-free securities — is historically high, and general market conditions remain unfavorable.

In some ways, stocks look cheap. In other ways, they look expensive. (Federal Reserve)

“Since late March, volatility has come down, but remains elevated relative to historical norms, and liquidity remains poor,” the Fed said.

In other words, the stock market continues to be risky.

And this commentary in part seems aimed at addressing the idea that the Fed is basically guaranteeing to investors that stock prices will continue to rise.

JPMorgan’s Marko Kolanovic wrote in April, that “Unhindered by moral hazard, the response of fiscal and monetary authorities is and will continue to be unprecedented, with the goal of essentially making everyone ‘whole.’” Analysts at Bank of America also recently posited that the market is betting on the shortest recession on record or the Fed buying equities.

Just four months ago that Chair Powell justified high stock market valuations by pointing to low interest rates. Now, the Fed finds itself explaining why significantly lower stock prices might be in store.

And more broadly, we’ve heard from more folks trying to emphasize the risks of losing money in the stock market over the opportunity for returns. Two weeks ago, even Warren Buffett took on a more cautious tone, saying you “have to be careful about how you bet, simply because markets can do anything.”

For the Fed, this language is timely and relevant as it continues to announce market-moving emergency measures. Moves which have left investors and traders speculating about what the Fed may or may not do next.

And the message from the Fed is clear: no promises.