Before you start reading this post note that I am not an equity market analyst and this is not investment advice. Rather it is an attempt to discuss the impact of monetary easing on the US stock market and to what extent the Fed’s actions have created a stock market bubble.

It is quite often said these days that the recovery we have seen in the US stock markets since early 2009 in some way is “phony” or “fake”, and that it has been driven by “easy money”. Even some policy makers, both in the US and other places, seem to think that there is a bubble in the global stock markets, which is a result of overly easy monetary policy.

To test these views in a simple way, I have estimated a model for the S&P500 going back to 1960. It is a simple OLS regression. You can do something more fancy, but that is not the point here. It is all indicative. If you have a better model, I would love to see it.

Take a look at the graph below. The blue is the actual performance of S&P500, while the green line is the model “prediction”. Please note that I have estimated the model until 2007 to avoid the results being influenced by the monetary policy shift over the past five years (it doesn’t change the result in any substantial way, however, to estimate the model until today).

As you see, the model fits the actual performance of S&P500 over the decades quite well. The model is quite simple. I used only three explanatory variables – A corporate Aaa-rate long-term bond yield to capture funding costs and/or an alternative investment to stocks. I used the nominal Personal Consumption Expenditure to capture demand in the US economy. It is also a proxy for earnings growth and finally I used the ISM New Orders index as a proxy for growth expectations. All variables have the expected signs and are statistically significant.

Yes, it is a simple model, but it seems to work quite well in terms of fitting the actual level on the S&P500 over the years.

If anything stocks are still cheap (and monetary policy too tight)

As mentioned, I estimated the model with data until 2007, but I have used the model to “predict” how the stock market should have performed according to the model from 2008 until today.

The results are quite clear: Since 2008, stock prices have consistently been lower than what the model predicts. Only recently have stock prices approached the level predicted by the model. Based on this, it is quite hard to argue that stock prices in the US are overvalued. In fact if anything stocks remain “cheap” relative to the model predictions.

I don’t want to argue this too strongly and I am certainly not giving any advice on whether to buy or sell the US stock market at these levels – all kind of things tend to move the market up and down. What I am arguing is that the view that there is a bubble in the US stock market is pretty hard to justify based on my simple model. If you can come up with a better model, which can show that there is a bubble, I am all ears.

Therefore, it is very hard to argue in my view that overly easy monetary policy has distorted the pricing of US stocks. What has happened rather is that stocks became extremely cheap relative to “fundamentals” in early 2009, and what we have seen in the past five years is a closing of this “valuation gap”. Has monetary policy helped close the “gap”? Yes, that is likely, but that is not the same as saying that there is a bubble.

Concluding, there is no empirical reason in my view to claim that US monetary policy has unduly inflated US asset prices. And hence the performance of the US stock market over the past five years is not an argument for monetary tightening. It anything it is an argument that monetary policy has remained too tight.

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PS if you are interested in the model output see below (it is not rocket science):

Model 1 S&P500, rebase 01-01-1960 = 100.0 Observations 576 Degrees of freedom 572 R2 0,9597105111 F 4541,7504443086 Prob-value(F) 0 Sum of squared errors 16279,404325032 Standard error of regression 5,3348380549 Durbin-Watson 0,0489587816 AIC 6,1933143441 HQ 6,2051117912 Schwarz 6,2235650918 Coefficients Standard error t Prob-value Intercept -627,703293948 7,0591041987 -88,9210976745 0 x1 -3,4836423233 0,096018312 -36,2810202582 0 x2 28,8240799392 0,2485205896 115,9826635779 0 x3 -0,0228854283 0,0303242775 -0,7546899778 0,4507456199 Legend x1 Corporate Benchmarks, Moody’s Aaa-Rated Long-Term, Yield, Average, USD x2 PCE x3 ISM PMI, Manufacturing Sector, New orders, SA Covariance matrix Intercept x1 x2 x3 Intercept 49,8309520883 0,0191128279 -1,6803093367 -0,067856727 x1 0,0191128279 0,0092195162 -0,0048925278 0,0007896205 x2 -1,6803093367 -0,0048925278 0,0617624835 0,0003876941 x3 -0,067856727 0,0007896205 0,0003876941 0,0009195618

