JWM Q1 Market Commentary: How Central Banks Have Changed the Investing Landscape

5 December, 2015

According to Sir John Templeton, the four most dangerous words in investing are “this time, it’s different.” This is an often used quote in the investing world. However, we also believe it is dangerous and naïve to think that all of the fundamental

According to Sir John Templeton, the four most dangerous words in investing are “this time, it’s different.” This is an often used quote in the investing world. However, we also believe it is dangerous and naïve to think that all of the fundamental drivers for stock market movement will remain the same forever.” 

"“In 2008, the global stock markets began a decline so severe that it is often compared to the 1929 stock market crash. In hindsight, it was easy to see many of the primary catalysts and the warning signs that should have been spotted. One of the biggest catalysts? The massive increase in the use of various different types of derivative products in our stock markets. Derivatives are investment securities that are comprised of various different types of underlying securities all wrapped into one product. They are more complex, they are relatively new to our stock markets, and the derivatives market is (still!) unregulated. When investment banks like Lehman Brothers wrapped up large quantities of sub-prime mortgages into an individual product? Those were derivatives. The Credit Default Swaps that contributed to the collapse of the Bear Sterns investment bank in 2008, almost bankrupted AIG investment bank, and was a large factor in that financial crisis? Also derivatives. These products had only been created in the past 20-25 years, and have only seen any significant use in the last 10-15.“ 

This time, it was different. 

There is no denying that our world is changing at a pace that increases almost exponentially as every year goes by. We believe it is irresponsible not to ask the question: how are things different? 

Something that has changed a great deal in the last decade is the more direct involvement of the world’s central banks in our stock markets. Historically, central banks’ most direct and impactful involvement has been their control over the key interest rate of a given nation. Today, we see central banks across the globe providing monetary stimulus in the form of quantitative easing as if this is standard procedure. It’s not. In 2008, the US Federal Reserve began what is now referred to as QE1, or quantitative easing, round 1. At the time, this move was viewed by most as unprecedented central bank action. The Fed would go on to issue QE2 and QE3 in later years. The European Central Bank would eventually implement similar monetary policy in the form of a quantitative easing program to help solve the Eurozone crisis that reared its ugly head in 2011. The Bank of England would follow suit, as would the Bank of Japan and the Swedish National Bank. Tell any financial analyst this would be the case even a decade ago and you’d be laughed out of the room.” 
 

Federal Reserve

“As a result of this continually increasing level of central bank involvement, investors now focus more and more on every public word issued by the central banks. While central banks aren’t new, this increased level of involvement paired with the heightened focus on their every move is – and you can thank the viral nature of the internet and social media in part for this heightened focus. You only need to watch the movement of our stock market indices on a day in which a statement is given by a central bank to see the effect. Markets move sharply and quickly in one direct or another when a central bank even hints at their intention of interest rate movement or a possible change in monetary stimulus. This has made our markets more sensitive and volatile, and it also has the potential to mean that stock prices may have diverged further from valuations that are tied more closely with the traditional fundamentals of a given corporation or other macroeconomic factors to determine value. In other words, central bank involvement has become an increasing factor in how our stock markets are priced. How much so? It’s tough to say. 

Is this bad? It could be. Is it different? Undeniably, yes, at least to the extent that we see now in comparison to past decades. It is also easy to make an argument, at least at this point in time, that these unprecedented central bank actions have helped prop up a global stock market that saw one of the worst recessions in over 70 years. Surely this would call for thinking outside of the box and the usage of whatever tools are at the disposal of those in charge, right? 

Because we are essentially in new territory, it is impossible to accurately predict how these new factors will affect the already overly complex system that is our stock markets and the underlying economies. We may look back in another 10 years of continued economic and market prosperity and wonder why on earth central banks didn’t use these tools earlier. We may look back and determine that, while these were valid and effective tools for central banks to employ, these programs were pushed too far and eventually caused too much collateral damage. What we do know is that complacency is a big part of human nature, and it’s important to be aware of the blind spots we can develop over even short periods of time. 

What can we do with all of this information? We can remain vigilant, and remember that every new variable in an equation makes it harder to predict the outcome. This is different, and this new variable needs to be taken into account and applied to the lens through which we view investing. 

Sources: Bloomberg, Reuters