Investors Are Supposed to Be Rewarded for Risk, Right?

After the Federal Reserve raised the federal funds rate as expected on Wednesday, investors are no doubt watching how longer-term interest rates respond. But the stock market’s moves will be just as revealing.  

U.S. stocks have been on a historic run since the 2008 financial crisis. The S&P 500 Index has returned 18 percent annually from March 2009 through August, including dividends, making it one of the best decades for stocks since 1926. It’s also the second-longest stretch without a bear market, as defined by a decline of 20 percent or more.

Bulls attribute much of that success to lower interest rates. It’s no coincidence that stocks skyrocketed soon after the Fed dropped rates in late 2008 in response to the financial crisis, they argue, and that the market kept moving higher while the Fed held rates low for years.  

The gist of the argument is that investors expect a premium for owning risky stocks rather than safe bonds — in technical jargon, an equity risk premium. When bond yields decline, stocks can pay less, too, provided that the premium stays roughly the same. But there’s little evidence investors are paying attention to the premium.

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Forget Banks and Worry About High Stock Prices

It’s time for investors to stop fighting the last war. The next downturn most likely won’t be triggered by another meltdown of the financial system.

The Federal Reserve has concluded its stress test of big banks, a look into whether they have enough money set aside to withstand another 2008-type financial crisis. The Fed announced last week that all 35 banks examined are sufficiently capitalized. It disclosedthe second and final round of results on Thursday afternoon, giving all but one bank a passing grade and the go-ahead to return money to shareholders.

Investors didn’t need the Fed to tell them that banks are in better shape than they were a decade ago. The signs are everywhere. Profits have fallen across the industry since the financial crisis, an indication that banks are taking on less risk. Profit margins for the S&P 500 Financials Index averaged 9.3 percent from 2008 to 2017, down from an average of 13.8 percent from 2003 to 2007, the years leading up to the crisis. Return on equity is down to an average of 5.2 percent from 14.5 percent over the same periods.

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Playing by the Taylor Rule

President Donald Trump fancies himself a disruptor, so it’s not surprising that Stanford economist John Taylor is on his shortlist to head the Federal Reserve.

But whether or not Trump taps Taylor for Fed chief, Taylor’s rules-based approach to monetary policy is in the Fed’s future.

The so-called Taylor rule is a formula that he proposed in 1993 for setting the federal funds rate — the overnight bank lending rate used by the Fed to fight inflation or stimulate the economy. It challenges the Fed’s traditional reliance on the Federal Open Market Committee’s ad hoc judgment.

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Stop Blaming Central Bankers

“My investment returns stink and it’s your fault, central bankers!”

That seems to be the battle cry of long-suffering investors navigating a world of zero interest-rate policies and more recently — gasp — negative interest-rate policies of central banks around the world.

With all the bellyaching about negative interest rates, you would think that investors have nowhere to turn for positive expected returns, but nothing could be further from the truth. The reality is that the returns are out there to be harvested, but investors don’t want to invest where those returns are likely to be. That’s hardly the fault of central banks.

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The Fed Isn’t Stealing Investors’ Candy

The Federal Reserve’s near-zero interest rate policy has had many far-flung effects, and none more significant than the fattening of the “equity risk premium” (defined as the expectation that stocks will deliver a higher return than “risk-free” investments such as cash).

Amid expectations for rising interest rates, that premium seemed to be on the chopping block. But the Fed breathed new life into it on Wednesday by holding rates steady and saying that it expects fewer rate hikes this year than it initially projected.

Stock investors shouldn’t celebrate just yet. They should instead reconsider whether the equity risk premium is the right gauge for thinking about how much they can expect to get paid for taking risk. Rather than hang on the Fed’s every word to divine the future course of interest rates, they should pay attention to the data and look elsewhere.

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