This article appeared in the AFR
When we get told something often enough, especially by so-called ‘experts’, it’s easy to accept it as a given. We’re all guilty of falling for the ‘narrative fallacy’ at times, sometimes through blind trust, sometimes because it appeals to our in-built biases.
The financial industry is plagued by this; someone gets asked to explain why something happened, they reach for the simplest explanation and before you know it that story gets accepted as gospel.
One such narrative fallacy we’ve all been told for ages now is that share markets have risen for the past several years because of super easy monetary policy pumping untold amounts of cash into the system that’s largely gone to chasing up asset prices, and without it the house of cards would come crashing down. This is supposed to be particularly true for the US, which has been the best performing global market in the post-GFC period, and where the Federal Reserve led the way in aggressive post-GFC monetary policy, such as the Zero Interest Rate Policy, fondly known as ZIRP, and Quantitative Easing, also frequently referred to as printing money.
You might be surprised to learn that narrative is wrong, baloney, a load of codswallop. The US market has gone up because of good old fashioned earnings growth.
John Bogel, the legendary founder of Vanguard, came up with a disarmingly simple formula for analysing why a share market has gone up or down. A market’s movements can only come from the combination of three things: dividends, earnings growth and the change in the price to earnings ratio (PE, which is really a measure of sentiment).
If share markets have risen because of all that freshly minted money chasing up asset values, then that would be reflected in a higher PE ratio.
A US blogger, Ben Carlson, recently worked out that since 2010 to the end of September this year (so three months shy of 10 years), the US market has returned 12.9% per year. Of that, dividends have contributed 2%, earnings growth 10.5% and the change in PE just 0.5%. That means the two ‘fundamental’ factors account for almost 97% of those annual returns. Not cheap money, not central bank market manipulation, just companies doing what they do.
The next thing you might think is ‘Hah, those earnings have been goosed by companies borrowing all that cheap money and buying back their shares’. Once again, believe it or not, this is just another popular narrative fallacy.
It’s true buybacks have averaged what sounds like an eye-popping US$5-600 billion per year since 2014, with 2018 a real outlier at US$900 billion thanks to President Trump’s tax cuts, however, JP Morgan concludes that between 2006-18, changes in margins and revenues accounted for about 93% of earnings growth, with the change in share count representing less than 7%.
Given the post-GFC monetary easing was ‘unprecedented’, as we are regularly reminded, it’s probably understandable that some would jump to the conclusion that it would have unprecedented effects. But the perpetuation of the fallacy that US share markets have gone up because of money printing is a classic case of people sticking with a narrative fallacy well after its use by date.
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