Fed’s aggressive monetary policy behind the stock market rally

The Federal Reserve Bank has been a controversial institution since the founding of our country.  Thomas Jefferson hated the idea, Alexander Hamilton championed the notion and prevailed. Jefferson bemoaned Hamilton’s ambitions in a letter to James Monroe: “We are ruined Sir, if we do not over-rule the principles that ‘“the more we owe, the more prosperous we shall be.’”  (James Monroe, A Life by, Tim McGrath.) The argument continues today.

It is no secret that easy monetary policy, which began in earnest during the Great Recession of 2008-2009, fuels higher stock prices. In December 2008 the Fed initiated “quantitative easing” and by March 9, 2009 stocks began a 10-year bull run. The Fed’s balance sheet grew over the ensuing six years to $4.5 trillion. Fast forward to March of 2020, as the economy shut down due to the Great Virus Crisis (aptly named by Dr. Ed Yardeni). The Fed acted swiftly and powerfully, snapping up corporate bonds and ETFs to provide liquidity to the credit markets. The balance sheet has ballooned to approximately $7 trillion in a matter of months. 

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Jerome Powell and friends have likely ensured the 2020 recession will be the shortest on record. And with the Fed backstopping financial assets, it is no surprise that stocks have rallied furiously off the March 23rd bottom.

On November 2nd of 2019, after the Fed eased interest rates, I wrote about the potential boon to stock prices and your 401(k). 

And then on February 23rd of 2020 as the market hit new highs, I suggested investors take a fresh look at 401(k) allocations (which is something you should be doing on a regular basis) and increase contributions, if possible, during any sell-off.

Now what?

Perhaps now is the time to consider increasing your exposure to growth stocks.  Why? Because there is an inverse correlation between the rise in the Fed’s balance sheet and the velocity of money.  Think of the velocity of money as Dolly Levi opined in the 1964 musical Hello, Dolly!:  “Money, pardon the expression, is like manure. It’s not worth a thing unless it’s spread around, encouraging young things to grow.”  If money is sitting on the Fed’s balance sheet it isn’t “encouraging young things to grow.” Why is that good for growth stocks?.  Stay with me.

Since the Great Financial Crisis—when the Fed expanded its balance sheet materially—the  U.S. economy experienced one of the slowest recoveries in history and value stocks dramatically underperformed growth stocks.  It is possible that trend will continue. While the economy is recovering quickly as states and communities reopen, consider that it may take some time for sustainable growth to return. When economic growth is slow, investors are willing to pay up for companies that can grow their revenues and earnings potentially driving growth stock prices up faster than the market as a whole.

Take a fresh look at your 401(k) allocations and ask yourself the following questions:

• Do my investment allocations reflect my current risk profile and expectations for the future? Managing your 401(k) is not just about your contribution allocations but also requires trimming back holdings that have performed well and adding to those you still have confidence in that have underperformed.  Don’t let the market make your asset allocation decision for you.
• Am I taking enough risk? You heard right. In my experience investors often over diversify or simply don’t take enough risk.  Even if you are retiring tomorrow you won’t need your entire 401(k) balance that day.  Make sure you maintain enough exposure to risk assets that can provide a hedge against inflation.
• What did I learn from the 2020 bear market?  Perhaps you learned that your risk tolerance is higher than you thought.

The Fed won’t carry the day forever. But, it is true investors can make money in just about every environment and political climate. Adjusting your 401(k) investments from time to time is prudent. This weekend pause that Netflix or Disney+ stream-fest and review your holdings. I plan to and will be looking for growthier opportunities to round out my holdings. 

This article originally appeared on USA TODAY: Fed’s monetary policy behind market rally and potentially short recession