Conspiracy theories are fun, but unfortunately they are often just that – theories – grown on the fertile soil of biased bloggers, journalists, or conspiracy groups.
Here’s a super enlightening piece of research published right on the website of the Federal Reserve Bank of New York. It comes straight from the horses mouth so to speak and tackles a very controversial subject.
The Fed – Stuck with the Hot Potato
The research talks about the equity premium. The equity premium is usually measured as the difference between the average return of the stock market (VTI) and the yield on short-term government bonds (SHY).
Analysts agree that the return of stocks should be greater than that of bonds to compensate for the volatility of stocks.
However, analysts can’t agree on the reason why the return of stocks is greater than that of short-term government bonds and what the return margin between stocks and government bonds should be to compensate for the extra risk linked to owning stocks.
This disagreement has given birth to the term “equity premium puzzle.”
David Lucca and Emanuel Moench (research posted on the New York Fed’s website) prove that: “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.” The researchers call this phenomenon a “drift.”
More than just a Drift
The pre-FOMC announcement drift is best summarized by 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 (^GSPC) stock market index over different three-day windows.
The solid black line (the chart is not as clear as it should be, but it’s taken directly from Lucca and Moench’s research) 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.
The dashed black line (at the bottom), 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. What does that mean?
The 55% FOMC Overvaluation
Let’s take a look at another chart to visualize the effect of the pre-FOMC announcement spike.
The chart below shows the S&P 500 (SPY) in blue and red. The blue line is the actual S&P 500 (IVV) performance, the red line (that’s where it gets interesting) is where the S&P would be if you exclude the returns on all 2 pm – 2 pm windows ahead of the FOMC announcement.
Excluding those returns the S&P would trade around 600, 55% below current prices.
The conclusion - after seeing the evidence Lucca and Moench have kindly provided – seems pretty obvious. But perhaps more surprising than the actual research itself is the ending statement of Lucca and Moench’s analysis: “The drift remains a puzzle.”
But the surprises don't end there. The research was intially published on July 11, 2012 when the S&P 500 traded at 1,340 (click here for original research on FOMC effect on S&P 500).
Furthermore, a recent Federal Reserve study warns of a 1987-like crash, but denies that the Federal Reserve contributed to stock market inflation. For more details read: Surprising New Fed Study - Is it Preparing American's for a Market Crash?
Simon Maierhofer is the publisher of the Profit Radar Report.
Follow Simon on Twitter @ iSPYETF
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